978-0077862213 Chapter 6 Case Point Blank Solutions

Unlock access to all the studying documents.

View Full Document

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.