SEC v. DHB Industries, Inc., n/k/a Point Blank Solutions, Inc.

Background

In the past few years, the SEC 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 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 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, with engaging in a massive accounting fraud. The

agency separately charged three of the companys former outside directors and audit committee

members for their complicity in the scheme. Exhibit 1 summarizes the accounting issues

included in the SECs 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. (for more details, see SEC filings attached)

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 Nadelmanfacilitated DHBs 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 DHBs then-CEO David Brooks

and CFO Dawn 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

DHBs internal controls over financial reporting by DHBs then-auditor Grant Thornton LLP and

its subsequent resignation; Numerous concerns reported to the audit committee by DHBs new auditors Weiser LLP (Weiser) in March 2004; Concerns raised with Weiser by the companys controller and the controllers intention to resign over inventory overvaluation; Weisers recommendation to the audit committee to investigate the inventory overvaluation issue; Weisers objection to the filing of DHBs 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 CEOs 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 CEOs corporate expenses; An April 2006 statement to the audit committee by DHBs new auditors, Rachlin, Cohen &

Holtz LLP, detailing DHBs 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.

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 20032004 could not be relied upon. On October 1,

2007, DHB filed a comprehensive Form 10-K, which included restated financial

statements for 2003, 2004, and 2005. The restated Form 10-K disclosed that DHBs 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 DHBs 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 DHBs 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 companys financial statements. These

manipulations caused DHBs annual reports to overvalue inventories materially by $24

million in 2003 and $30 million in 2004, and caused the company to overvalue its

inventories materially 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 and

accounting for impairments in value). DHBs failure to report its inventory values

properly inflated its gross profit and net income falsely in its public filings and earnings

releases.

1. In 2004, approximately $12.5 million of hard armor plates, a key component

of DHBs vests, became obsolete when the U.S. Army changed specifications

for the plates. Because the U.S. military was DHBs main customer, this

meant that the company could not use those armor plates in marketable vests.

2. 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 that it could not sell.

3. 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 pretax

income for 2004 by at least $17 million.

4. 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 pretax 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, selling, general, and administrative expenses, pretax income,

net income, and other key figures in conformity with GAAP. DHBs lack of internal

controls resulted in the filing of materially false and misleading earnings releases and

public filings with the SEC.

1. 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.

2. These expenses, which benefited Brooks and others, included such items as

luxury cars, jewelry, art, real estate, extravagant vacations, use of personal

aircraft, prostitutes, horse training, and clothing and accessories from highfashion designers such as Hermes and Louis Vuitton, and more than $120,000

for iPods included in gift bags for guests at a multimillion-dollar party for his

daughter.

3. DHB paid for $975,000 of Brookss 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 Brookss 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 companys reported gross profit margin by reclassifying amounts

from cost of goods sold to research and development, an expense category on DHBs

income statement.

1. These reclassification entries had the effect of materially understating

DHBs cost of goods sold and overstating its expenses, resulting in an

overstatement of DHBs gross profit (with no effect on net income and

related per-share data).

2. CFO Dawn Schlegel (with Brookss 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

greater than DHBs actual cost of samples.

3. DHBs 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 DHBs gross profits reported in its earnings releases

and public filings.

Related-Party Transactions From at least 2003 through 2006, Brooks funneled

approximately $10 million out of DHB to a related party and did not disclose the nature

of the business arrangement.

1. Although Brookss wife was listed as running the related-party entity, Brooks

actually authorized and reviewed all of the entitys checks prior to

disbursement, personally signed the checks, directed Schlegel to sign his

wifes name to the checks, authorized the payment of bonuses to employees

(including horse trainers) out of DHBs accounts, controlled the price that the

entity charged DHB for plates, and made decisions regarding its capital

expenditures and personnel.

2. The entity spent the majority of proceeds that it received from the sale of the

plates to DHB on Brookss horse racing empire, or Brooks transferred the

money to another entity that he controlled.

The same day that 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.

2. Conduct research to determine what Section 10(b) and Rule 10b(5) of the Securities

Exchange Act of 1934 cover. Provide the sections of the act, properly referenced, and a

summary in your own words.

3. Did the audit committee members act ethically? Use one of the models of ethical

behavior discussed in chapter 2 (Kohlberg, Rest, or Jones) to evaluate the ethical actions

of the audit committee.

4. What corporate governance deficiencies existed?

5. The case states that the audit committee lacked independence. In what ways did these

individuals lack independence?

6. What are the responsibilities of the audit committee and what responsibilities did these

individuals fail to uphold?

7. Explain how each of the bulleted items in Exhibit 1 could lead to investor misconceptions

about the companys financial position and/or results of operations.

8. Describe the ethical behavior of the auditors in resigning from the engagement.