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Case 6-6
SEC v DHB Industries, Inc., n/k/a Point Blank Solutions, Inc
Background
In the past few years, the U.S. Securities and Exchange Commission has stepped up its enforcement actions
against independent directors of publicly traded companies. While the commission historically has not
pursued public company directors, it does so when it deems the directors to have knowingly permitted or
facilitated violations of the securities laws. Historically, the SEC pursues cases against independent
directors only when it believes that they personally have engaged in improper conduct or have repeatedly
ignored significant red flags. The action discussed below illustrates how the commission may choose to use
some of its new enforcement powers under the Dodd-Frank.
On February 28, 2011, The SEC charged DHB, a major supplier of body armor to the U.S. military and law
enforcement agencies, for engaging in a massive accounting fraud. The agency separately charged three of
the company’s former outside directors and audit committee members for their complicity in the scheme.
Exhibit 1 summarizes the accounting issues included in the SEC’s filing against the company for violations
of Section 10(b) and Rule 10b(5) of the Securities Exchange Act of 1934. The filing alleges the following:
From at least 2003 through 2005, DHB, in connection with the purchase or sale of securities as
described herein, by the use of means or instrumentalities of interstate commerce or of the mails,
directly or indirectly, knowingly, willfully, or recklessly: (a) employed devices, schemes, or
artifices to defraud; (b) made untrue statements of material facts or omitted to state material facts
necessary in order to make the statements made, in the light of the circumstances under which they
were made, not misleading; or (c) engaged in acts, practices, or courses of business which
operated as a fraud or deceit upon other persons.
Action against Independent Directors and Audit Committee Members
The commission filed a complaint in federal court against three former “independent” directors of DHB
Industries, Inc. (“DHB”), now known as Point Blank Solutions, Inc., who had served as members of the
audit committee. The complaint alleged that the three former board members—Jerome Krantz, Cary
Chasin, and Gary Nadelman—facilitated DHB’s securities violations through their “willful blindness to red
flags signaling fraud” between 2003 and 2006. Their actions allegedly allowed senior management to file
materially false and misleading filings with the commission and use corporate funds to pay for personal
expenses.
The complaint also alleged that the directors’ actions allowed DHB’s then-CEO David Brooks and CFO
Frank Schlegel to divert corporate funds to a personally controlled entity. The complaint further alleged that
the three directors lacked independence because of their business relationships and decades-long social
relationships with the CEO. The complaint alleged that the directors omitted from the official board
minutes discussions of company expenditures that had no legitimate business purpose (e.g., paying for
prostitution services), made little or no effort to understand their audit committee responsibilities, and
“turned a blind eye to numerous, significant, and compounding red flags. The red flags included, among
other warning signs, the following:
The August 2003 issuance of a material weakness letter to the audit committee concerning DHB’s
internal controls over financial reporting by DHB’s then-auditor Grant Thornton LLP and its
subsequent resignation
Numerous concerns reported to the audit committee by DHB’s new auditors Weiser LLP
(“Weiser”) in March 2004
Concerns raised with Weiser by the company’s controller and the controller’s intention to resign
over inventory overvaluation
Weiser’s recommendation to the audit committee to investigate the inventory overvaluation issue
Weiser’s objection to the filing of DHB’s 2004 annual report and a March 2005 material weakness
letter issued by Weiser, followed by its resignation
The January 2004 resignation of Gibson, Dunn & Crutcher LLP (“Gibson Dunn”), which had been
hired as outside counsel to investigate potential related-party transactions between the CEO and an
entity allegedly controlled by the CEO
The CEO’s insistence that he oversee any future investigation of related-party transactions by the
law firm Pepper Hamilton LLP and the consulting firm FTI Consulting, Inc. (“FTI”), hired after
the resignation of Gibson Dunn, and the subsequent firing of FTI by the CEO after FTI began to
question the CEO’s corporate expenses
An April 2006 statement to the audit committee by DHB’s new auditors Rachlin Cohen and Holtz,
LLP, detailing DHB’s inventory manipulations in the first three quarters of 2005.
The complaint alleged that the three audit committee members systematically and repeatedly failed to
investigate these and other red flags, failed to address specific concerns, and allowed fraudulent activity by
the CEO and other members of the senior management to continue unabated.
The same day the SEC filed its complaint against the three directors of DHB, the commission filed a
separate complaint against the company (which is now under new management and led by new board
members) for securities fraud. DHB has settled the charges and agreed to a permanent injunction from
future violations.
Questions
1. Identify the stakeholders in this case and the ethical obligations of independent members of the
board of directors and audit committee to these parties.
The stakeholders in this case include the public, shareholders, creditors, employees, suppliers, accounting
profession, regulators, the military, soldiers, police, and taxpayers. These stakeholders are owed a duty of
care, loyalty, and good faith by the audit committee, directors, and officers. The independent board and
• monitoring the integrity of DHB's financial reporting process and systems of internal controls;
• monitoring the independence and performance of DHB's independent auditors;
• providing an avenue of communication among the independent auditors, Company management,
and the Board of Directors;
2. What are the legal liabilities of board members and members of the audit committee? Analyze
the facts of the case and comment whether they violated their legal ethical obligations.
Despite the above enumerated duties and responsibilities of the audit committee, and despite Brooks'
having a previous history of securities violations (in 1992, the Commission obtained a permanent
injunction and $405,000 civil penalty against Brooks and barred him from association with any broker or
dealer for five years, related to his role in an insider trading scheme), Jerome Krantz, Cary Chasin, and
Board members and audit committee members owe a duty of care, loyalty, and good faith to the
shareholders. It appears from the facts of the case that these obligations were not met as red flags were
ignored leading to the filing of materially misleading financial statements with the SEC. The directors
3. Are there any parallels in the case with the Tyco case discussed in Chapter 5? What are they?
Evaluate the role that internal controls played in each case.
DHB lacked internal accounting controls over the use of corporate checks and credit cards, enabling
Brooks to use DHB as his personal piggy bank. Between 1997 and 2005, Brooks used DHB checks and
corporate credit cards to divert approximately $4.7 million in Company funds to his private entities (family
horse breeding and racing) and to pay for millions of dollars in personal expenses. These expenses included
Brooks demanded absolute loyalty from his board members and employees. He then rewarded the
loyalty with lucrative rewards. Krantz, Nadelman, and Chasin, each received lucrative warrants in 2003,
There are parallels with the Tyco case where Denis Kozlowski used corporate funds for personal
purchases of houses, art, yachts, and a lavish birthday party for his wife. In both cases the board of directors
DHB needed internal controls over disbursements to ensure that the payments were for legitimate
business expenses. DHB needed a dollar amount limit over purchases and disbursements required board
Exhibit 1
Accounting Fraud Issues at DHB
On April 3, 2006 and August 18, 2006, DHB filed a Form 8-K stating that its interim reports for 2005 and
financials for 2003-2004 could not be relied upon. On October 1, 2007, DHB filed a comprehensive Form
l0-K, which included restated financial statements for 2003, 2004, and 2005. The restated Form 10-K
disclosed that DHB's gross profit margins and net income for 2003 and 2004 were materially lower than the
Company had previously reported. These restated financials eliminated all of DHB's 2003 and 2004 profits.
Overstated Inventories
Between 2003 and 2005, DHB overstated its inventory quantities and created bogus, unsubstantiated bills
of material to price its "work in process" and "finished goods" inventory. These fraudulent bills of material
overstated labor costs, the amount of raw materials, overhead costs, and the unit prices of DHB's four
primary vest components. Throughout this period, DHB, falsely adjusted its inventory schedules to increase
the inventory value. Schlegel and Brooks were aware the inventory was overvalued, but did nothing to
correct the Company's financial statements.
These manipulations caused DHB's annual reports to materially overvalue inventories by $24 million in
2003 and $30 million in 2004, and caused the Company to materially overvalue its inventories by $33
million in its quarterly report as of September 2005. By overvaluing its inventories, DHB also materially
overstated its reported gross profit and net income during these periods.
Excess and Obsolete Inventory
Between 2003 and 2005, DHB further manipulated its inventory valuation by failing to account properly
for excess and obsolete inventory as GAAP required, i.e. valuing inventory at the lower of cost or market
value. DHB's failure to properly report its inventory values falsely inflated its gross profit and net income
in its public filings and earnings releases.
In 2004, approximately $12.5 million of hard armor plates, a key component of DHB's vests, became
obsolete when the U.S. Army changed specifications for the plates. Since the U.S. military was DHB's
main customer, this meant the Company could not use those armor
plates in marketable vests.
An additional $4.5 million of inventory became obsolete due to other specification changes, including the
discontinuation of certain vest colors and fabrics. The changed specifications left DHB with a large
inventory of plates and fabrics it could not sell.
DHB and others should have disclosed the known material risk and uncertainty concerning the
marketability of these plates and established an inventory valuation reserve by recognizing an obsolescence
charge for the plates in its 2004 Form 10-K. However the Company failed to do so, thereby falsely
misrepresenting and overstating its inventory, gross profit, and pre-tax income for 2004 by at least $17
million.
DHB and others additionally failed to recognize charges for impaired inventory totaling $1 million in 2003
and $6 million as of September 2005. This caused DHB to materially understate its cost of goods sold and
materially overstate its gross profit and pre-tax income stated in its annual reports.
Internal Controls
DHB failed to devise and maintain internal controls sufficient to provide reasonable assurance that DHB
accounted for its inventory, cost of goods sold, gross profit, gross margin, SG&A expenses, pre-tax income,
net income, and other key figures in conformity with GAAP. DHB's lack of internal controls resulted in the
filing of materially false and misleading earnings releases and public filings with the Commission.
DHB lacked internal accounting controls over the use of corporate checks and credit cards, enabling
Brooks to use DHB as his personal piggy bank. Between 1997 and 2005, Brooks used DHB checks, and
corporate credit cards to divert approximately $4.7 million in Company funds to his private entities and to
pay for millions of dollars in personal expenses.
These expenses benefited Brooks and others and included such items as luxury cars, jewelry, art,
real estate, extravagant vacations, use of personal aircraft, prostitutes, horse training, clothing
and accessories from high fashion designers such as Hermes and Louis Vuitton, and more than
$120,000 for iPods included in gift bags for guests at a multi-million dollar party for his
daughter.
DHB paid for $975,000 of Brooks' personal expenses in 2003, $788,000 in 2004, and $1.3 million in 2005.
In addition, between 1997 and 2002, DHB paid for at least $1.7 million of Brooks' personal purchases on
corporate credit cards. Brooks did not repay DHB these amounts.
Fraudulent Expense Reclassification Entries
Between 2003 and 2005, DHB and others also manipulated the Company's reported gross profit margin by
reclassifying amounts from cost of goods sold to "research and development," an expense category on
DHB's income statement. These reclassification entries had the effect of materially understating DHB's cost
of goods sold and overstating its expenses, resulting in an overstatement of DHB's gross profit (with no
effect on net income and related per share data).
Chief Financial Officer, Dawn Schlegel (with Brooks' knowledge) routinely directed members of the
accounting staff to record journal entries that reclassified these expenses without any supporting
documentation. DHB recorded these bogus amounts as research and development expenses,
purportedly relating to sample vests provided to sales personnel and customers. However, these
amounts were baseless because, among other things, they represented tens of thousands more
sample vests than DHB normally used. Furthermore, the corresponding overstated expenses were several
times more than DHB's actual cost of samples.
DHB's fraudulently reclassified entries totaling $8.8 million in 2003, $7.1 million in 2004, and $8.2 million
as of September 2005, resulting in a material increase to DHB's gross profits reported in its earnings
releases and public filings.
Related-party Transactions
From at least 2003 to 2006, Brooks funneled approximately $10 million out of DHB to a related party and
did not disclose the nature of the business arrangement.
Although Brooks' wife was listed as running the related-party entity, Brooks actually controlled Brooks
authorized and reviewed all of the entity’s checks prior to disbursement, personally signed the checks,
directed Schlegel to sign his wife's name to the checks, authorized the payment of bonuses to employees
(including horse trainers) out of DHB's accounts, controlled the price the entity charged DHB for plates,
and made decisions regarding its capital expenditures and personnel. The entity spent the majority of
proceeds it received from the sale of the plates to DHB on Brooks' horse racing empire, or Brooks
transferred the money to another entity he controlled.
