Corporate Disclosure and the Role of Outside Directors: SEC v. Krantz (The Duty of Audit Committee Directors to Respond to Auditor Concerns) (Part 3)

The Complaint in this case sets out a list of what not to do as a member of the audit committee. 

The Complaint (which contains only allegations since the case hasn't settled or otherwise been resolved on the merits) criticized the outside directors on the audit committee because they did not understand their function.  As the document stated, the outside directors "made little or no effort even to understand their Audit Committee responsibilities."

In addition, however, the outside directors were told by their auditors about problems with the Company's system of internal controls.  One auditing firm resigned and, on the same day, issued a material weakness letter to the committee concerning the internal controls.  As the complaint stated:

• The auditors' concerns focused on understaffing in [Company's] accounting department, [Company's] lack of a comprehensive or formal inventory management system, and the Company's failure to disclose TAP [a company allegedly controlled by the CEO] as a related entity. In its material weakness letter, [the firm] stated "there is currently no review process in place to ensure that data is entered into the system accurately and that inventory balances at any point in time are stated fairly. We recommend that the Company acquire and implement a comprehensive inventory management system to assist management in properly managing and controlling inventory in a consistent and organized manner."

The replacement auditors likewise reported problems with the Company's controls to the audit committee.  Again, as the complaint stated: 

• [The auditors] informed the Audit Committee that [the Company's] inventory tracking system was inadequate and that the Company needed a comprehensive inventory management system. In late March or early April 2004, [the firm] told [the Company] and the Audit Committee to retain a CFO for the Company's Florida operations, a Director of Financial Reporting, a cost accountant responsible for inventory cost accounting and reporting, and they wanted a new financial expert, instead of [one of the outside directors], to serve on the Audit Committee.

The outside directors apparently failed to heed the concerns expressed by the auditors, but not entirely.  The company did hire a new controller. 

Problems with inventory valuation ultimately had serious consequences.  The Complaint alleged that the inventories were overvalued:

• by approximately $24 million in 2003 and approximately $30 million in 2004, and caused the Company to materially overvalue its inventories by approximately $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.

In other words, the Commission is sending a very clear message that directors must know their duties and must heed warnings about failures in the system of internal controls. Audit committees cannot assume that the auditor will correct the problem.  Failing to do so can result in charges under the antifraud provisions.

For more detail, see the Litigation Release in SEC v. Krantz, Litigation Release No. 21867 (SD Fla Feb. 28, 2011) as well as the Complaint.