SECURITIES ACT OF 1933
Release No. 7636 / February 2, 1999
SECURITIES EXCHANGE ACT OF 1934
Release No. 41012 / February 2, 1999
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1104 / February 2, 1999
File No. 3-9822
|In the Matter of
|Order Instituting Public Administrative
Proceedings, Making Findings, and
Instituting a Cease-and-Desist Order
The Commission deems it appropriate that public administrative proceedings be, and hereby are, instituted against Donnkenny, Inc., pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Section 21C of the Securities Exchange Act of 1934 (Exchange Act).
In anticipation of the institution of these proceedings, Donnkenny has submitted an offer of settlement, which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained in this order (except that Donnkenny admits that the Commission has jurisdiction over it and over the subject matter of these proceedings), Donnkenny consents to the entry of the findings and the institution of the cease-and-desist order set forth below.
The Commission finds the following: 1
1. Respondent: Donnkenny, Inc.
Donnkenny, Inc., is a Delaware corporation with its principal executive offices in New York, New York. Donnkenny designs, manufactures, imports and markets moderately priced women's sportswear and other sportswear featuring the images of licensed cartoon characters. The company's common stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and is quoted on the Nasdaq national market system. As of September 30, 1998, the company had approximately 14.2 million shares of stock outstanding.
Beginning in at least early 1994 and continuing until August 1996, under the direction of four former employees, Donnkenny engaged in a financial fraud to create the illusion that each quarter the company's financial results met or exceeded projections and analysts' expectations. To create this illusion, Donnkenny's former chief executive officer (CEO), chief financial officer (CFO), controller, and assistant controller participated in a scheme whereby the company improperly reported revenue on bogus transactions as well as on sales before they occurred. As a result of the actions of these former employees, Donnkenny violated the antifraud, periodic reporting, books and records, and internal accounting control provisions of the federal securities laws.
As part of the fraudulent scheme, Donnkenny improperly recognized revenue on:
- out-of-period shipments by holding open quarters,
- anticipated future sales by pulling forward "bulk" orders without shipping goods to customers,
- fictitious sales both from non-existent contract work and through false journal entries, and
- inventory held at an idle Donnkenny facility and at a third-party warehouse.
As a result of the scheme, Donnkenny's financial statements and other disclosures in its registration statement in April 1994 and periodic filings with the Commission for fiscal years 1994, 1995, and the first two quarters of 1996, were materially false and misleading. 2
|1||The findings herein are made pursuant to Donnkenny's offer of settlement and are not binding on any other person or entity in these or any other proceedings.|
|2||The following table compares Donnkenny's originally reported net income with the net income that the company reported in its restated financial statements.|
|First Quarter||Second Quarter|
|($$ in 000's)||Originally
Net Income (Loss)
Net Income (Loss)
Net Income (Loss)
|Third Quarter||Fiscal Year|
|($$ in 000's)||Originally
Net Income (Loss)
Net Income (Loss)
Net Income (Loss)
In addition, during the course of the scheme, Donnkenny issued materially false and misleading press releases concerning the company's actual and expected financial results.
3. The Scheme
Beginning in at least fiscal year 1994, near the end of each fiscal quarter, former executives of Donnkenny would establish a specific revenue amount or earnings per share figure that the company would report that quarter. The former controller and former assistant controller would then through a combination of improper practices ensure that the company recorded enough revenue to meet the targeted figures. After the fraudulent revenue was recorded, the former assistant controller would track the underlying transactions so that Donnkenny could reverse them in subsequent quarters. The company reversed some, but not all, of the improper transactions by fiscal years' end.
Donnkenny achieved the targeted figures through a combination of the following improper methods:
a. Donnkenny Recognized Revenue on Out-of-Period Shipments by Holding Quarters OpenS
For every quarter during fiscal years 1994 and 1995 and in the second quarter of 1996, Donnkenny's books and records were held open at the end of the quarter to record revenue in one quarter on goods shipped in the next quarter. The number of days that the quarters were held open varied from one or two to over seven. Holding the quarters open artificially inflated Donnkenny's sales by at least $600,000 to
$4 million each quarter.
This practice was widely known by the company's employees and, in fact, pre-dated the company's going public in June 1993. The practice was such an integral part of the company's operations that personnel from Donnkenny's management information systems department wrote a program to automatically freeze the computer date while the quarter was held open. As a result, for days after a quarter's end, reports generated by Donnkenny's computer system were dated the last day of the previous quarter.
b. Donnkenny Recognized Revenue on Anticipated Future Sales by Pulling Forward Bulk Orders
Donnkenny's customers often placed large, or bulk, orders months in advance because they were ordering clothing for future fashion seasons. While these orders indicated which clothing the customers wanted, key terms (such as the shipping dates and destinations) were missing and supplied later.
For the first three quarters of fiscal year 1994 and for each quarter during
fiscal year 1995, Donnkenny recognized revenue on bulk orders without contemporaneously shipping the goods. This practice worked as follows:
- Donnkenny's accounting personnel would invoice the bulk orders, thereby recording revenue.
- The accounting personnel would then pull and not mail the false invoices.
- Finally, in subsequent quarters, if and when the customers finalized their orders by providing shipping instructions, the accounting personnel would void the false invoices, issue and send real invoices, and ship the goods to the customers.
During the first three quarters of 1994, Donnkenny improperly recorded
$15.2 million in revenue from bulk orders, ranging from $1.4 million to $9.9 million per quarter. By fiscal year-end 1994, Donnkenny had reversed this improper revenue. Therefore, while the bulk orders had a material impact on Donnkenny's quarterly net sales, they had no impact on the company's annual net sales for fiscal year 1994.
In fiscal year 1995, Donnkenny improperly recorded a total of $11.3 million in revenue from bulk orders, ranging from $800,000 to $5.2 million per quarter. These bulk orders had a material impact on Donnkenny's quarterly and annual net sales because the company failed to reverse $800,000 of the improperly recorded revenue by fiscal year-end. The company reversed this remaining $800,000 during the first quarter of 1996.
c. Donnkenny Recognized Revenue on Phony Sales
(1) non-existent contract work
In addition to its own manufacturing activities, Donnkenny performed contract work (such as assembling clothes) for other manufacturers when it had excess capacity. During the first quarter of 1995, to meet the company's revenue target, Donnkenny's accounting personnel created phony invoices for non-existent contract work. The dollar amount of these invoices, $6.1 million, represented nearly 16 percent of the quarter's total reported sales. At the former controller's direction, the company reversed this revenue in subsequent quarters.
(2) false journal entries
In the first three quarters of fiscal year 1995 and the first two quarters of
fiscal year 1996, Donnkenny used journal entries to record revenue to artificially achieve the targeted financial results. These entries increased both sales and inventory, which made no sense from an accounting standpoint. The entries merely provided a simpler way to falsely inflate revenue: They created instant sales and eliminated the need to create, pull, track, and eventually credit false invoices, all of which were
time-consuming and created bookkeeping problems. Each quarter the false entries ranged from $5.5 million to $26.1 million. In total, Donnkenny recorded $41.6 million in phony revenue during the first three quarters of 1995 using journal entries. The company recorded an additional $22.4 million in phony revenue through journal entries during the first two quarters of 1996.
Of the $41.6 million in revenue Donnkenny recorded using journal entries during fiscal year 1995, $26.1 million was recorded in the second quarter alone. At the time, the company had no real sales to correspond with the entries, and lacked orders and inventory sufficient to satisfy the purported sales. At the close of the second quarter of 1995, the former CFO authorized a journal entry to reclassify $11 million from inventory to accounts receivable. The former CFO authorized the reclassification to conceal the fraud because as a result of the false journal entries the company's recorded accounts receivable were too low in relation to its reported net sales.
By the end of fiscal year 1995, the company had reversed all but $12 million of the $41.6 million in fictitious sales it had recorded through journal entries during that year's first three quarters. The company, in effect, reversed the remaining $12 million with a journal entry increasing cost of sales by $12 million. Thus, by year-end, the company no longer overstated its net income through these false journal entries. The company, however, still overstated its net sales and cost of sales by $12 million. Reversing the remaining $12 million in false sales in this manner allowed Donnkenny to report net sales of approximately $210 million for fiscal year 1995, nearly matching analysts' expectations of net sales of $212 million.
4. Donnkenny Recognized Revenue on Inventory Held at an Idle Facility and Third-Party Warehouse
When Donnkenny recognized revenue on bulk orders and other false sales at year-end, a step was added to the scheme: Donnkenny moved the corresponding inventory to avoid possible detection during the company's annual physical inventory count observed by its independent auditors.
At year-end 1994, Donnkenny recognized revenue totaling $7 million on purported sales of inventory held at an idle Donnkenny facility and in a third-party warehouse. As to the goods held in the third-party warehouse, days before Donnkenny's fiscal year 1994 ended, the former CEO met with one of the company's importers. At the meeting, the former CEO asked the importer to take and hold "on consignment" Donnkenny inventory. The importer responded that they would try to sell the clothing, but expressed doubts about their ability to succeed. During the meeting, the former CEO agreed that the goods would continue to belong to Donnkenny, and that if the goods were not sold by March 1995, the importer could return them to Donnkenny. The importer agreed to take the goods on consignment.
After the meeting, Donnkenny shipped the inventory to the third-party warehouse and recorded a sale of $4.4 million. In reality, this transaction was not a sale or even a consignment; it merely allowed Donnkenny to record sham revenue and conceal the corresponding inventory from its auditors. Donnkenny paid all charges to ship, insure, and warehouse the goods. During the first two quarters of 1995, all the goods came back to Donnkenny at Donnkenny's instruction, initially without the importer's knowledge. Donnkenny never sent an invoice for the goods and never provided the importer with the prices of the clothing, thereby preventing the importer from even attempting to sell the goods.
Similarly, near year-end 1995, Donnkenny moved inventory to an inactive Donnkenny facility to hide the goods from its auditors during the annual physical inventory count. The hidden inventory corresponded to invoices recorded for bulk orders and other phony sales. As a result, the company overstated its net sales by approximately $6.4 million at fiscal year-end 1995.
B. LEGAL ANALYSIS
1. Donnkenny Violated the Antifraud Provisions of the Federal Securities Laws.
Generally, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit the use of a scheme or the making of material misrepresentations or omissions, with scienter, in connection with the purchase or sale of securities. Section 17(a) of the Securities Act prohibits similar conduct in the offer or sale of securities, but under certain circumstances does not require a showing of scienter. Both knowing and reckless conduct satisfies the scienter requirement. Rolf v. Blyth Eastman Dillon & Co., 570 F.2d 38, 46 (2d Cir. 1978), cert. denied, 439 U.S. 1039 (1978). To establish a corporation's scienter, the mental states of its officers can be imputed to the corporation. SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1096 n.16 (2d Cir. 1972).
Through the actions of its former employees, Donnkenny violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 by engaging in a scheme whereby it improperly reported revenue to create the illusion that each quarter its financial results met or exceeded projections and analysts' expectations. As part of the scheme, Donnkenny provided materially false and misleading information in press releases and financial statements and other disclosures in periodic filings with the Commission and in the company's April 1994 registration statement. See Basic, Inc. v. Levinson, 485 U.S. 224 (1988); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 860-62 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
2. Donnkenny Violated the Reporting Provisions of the Exchange Act.
Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission factually accurate annual and quarterly reports. SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Rule 12b-20 of the Exchange Act also requires that periodic reports contain all information necessary to ensure that statements made in those reports are not materially misleading. Through the actions of its former employees, Donnkenny violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder by, as part of its fraudulent scheme, disseminating to the public and filing with the Commission periodic reports that contained materially false and misleading information. See, e.g., Sensormatic Electronic Corp., Securities Act Rel. No. 7518 (Mar. 25, 1998).
3. Donnkenny Violated the Record-Keeping and Internal Control Provisions of the Exchange Act.
Section 13(b)(2)(A) of the Exchange Act required Donnkenny to make and keep books, records, and accounts that, in reasonable detail, accurately and fairly reflected its transactions and dispositions of assets. Section 13(b)(2)(B) of the Exchange Act required Donnkenny to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that its transactions were recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles (GAAP).
Donnkenny's scheme of recording revenue from out-of-period shipments, anticipated future sales, and bogus transactions involved the preparation of, among other things, false invoices and fictitious journal entries. Such documents were integral to Donnkenny's ability to prepare its financial statements. By inaccurately recording revenue in its books and records, Donnkenny violated Section 13(b)(2)(A). Donnkenny also violated Section 13(b)(2)(B) by failing to devise and maintain a system of internal accounting controls that assured that its financial statements were prepared in accordance with GAAP. Among other things, Donnkenny lacked internal controls sufficient to ensure the accuracy of its recorded revenue and to prevent or detect the resetting of its computer clock.
Based on the foregoing, the Commission finds that Donnkenny violated Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder.
In view of the foregoing, the Commission finds that it is appropriate to impose the relief agreed to in Donnkenny's offer. Accordingly, it is hereby ordered, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that:
Donnkenny cease and desist from committing or causing any violations, and any future violations, of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange
Act and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder.
By the Commission.
Jonathan G. Katz