Osherow v. Ernst & Young

• Decision Date: 25 January 2000
• Docket Number: No. 98-51085,98-51085
• Citation: 200 F.3d 382
• Parties: (5th Cir. 2000) IN THE MATTER OF: INTELOGIC TRACE, INC., DEBTOR RANDOLPH N. OSHEROW, TRUSTEE, Appellant, v. ERNST & YOUNG, LLP, Appellee
• Court: U.S. Court of Appeals — Fifth Circuit

Page 382

200 F.3d 382 (5th Cir. 2000)

IN THE MATTER OF: INTELOGIC TRACE, INC., DEBTOR

RANDOLPH N. OSHEROW, TRUSTEE, Appellant, v. ERNST & YOUNG, LLP, Appellee.

No. 98-51085

IN THE UNITED STATES COURT OF APPEALS, FIFTH CIRCUIT

January 25, 2000

Appeal from the United States District Court for the Western District of Texas

Before GARWOOD, SMITH, and BENAVIDES, Circuit Judges.

GARWOOD, Circuit Judge:

Plaintiff-Appellant Randolph N. Osherow ("Trustee"), the bankruptcy trustee of Chapter 7 debtor Intelogic Trace, Inc. ("IT"), brought this action in state court against Defendant-Appellee Ernst & Young, LLP ("Ernst & Young"), alleging, inter alia, negligence and professional malpractice arising from services Ernst & Young performed during IT's previous Chapter 11 bankruptcy proceeding. The case was removed to the bankruptcy court under 28 U.S.C. 1452. The Trustee now appeals on behalf of IT the bankruptcy court's decision, subsequently affirmed by the district court, granting summary judgment in favor of Ernst & Young on the basis that the Trustee's claims were barred by res judicata. We affirm.¹

FACTS AND PROCEEDINGS BELOW

In 1994, IT, a software and technical services provider in the computer industry, began experiencing cash flow difficulties and consequently initiated bankruptcy proceedings under Chapter 11 on August 5, 1994. On September 2, 1994, the bankruptcy court approved the employment of Ernst & Young to assist IT in accounting related matters during the bankruptcy. Ernst & Young's services fell into two main areas: first, the performance of the annual audit of IT's July 1994 financial statements, including the completion of IT's Form 10K to be filed with the Securities and Exchange Commission; and second, consultation and negotiation with the Internal Revenue Service in connection with an ongoing examination of IT. IT pursued a fast-track reorganization and emerged from Chapter 11 through a confirmed plan on December 8, 1994.

Pursuant to the confirmed plan, Kevin Collins ("Collins") became chairman of IT's Board of Directors ("the Board"). Collins testified that, despite all the Board's efforts and the services provided to IT, by December 23, 1994 the Board "had serious concerns about the company's numbers and the state of the company's liquidity."

On January 8, 1995, Ernst & Young filed in the bankruptcy court an application for $217,237 in fees and $1,743 in expenses incurred in connection with IT's Chapter 11 reorganization. Other service providers filed similar applications, and a hearing was set for January 23, 1995. Upon receipt of notice of the fee application, the Board, acutely aware of IT's cash flow difficulties, began to have heightened concerns about flaws in IT's cash projections and whether there might have been a problem with the professional work in preparing these projections. In fact, Collins in his deposition stated that "by mid-January we considered the cash situation to be critical."

Despite these concerns, the Board, acting on the advice of its General Counsel Philip Freeman ("Freeman"),² affirmatively decided not to raise these concerns at the fee hearing before the bankruptcy court. Collins testified that the Board and Freeman did not want the bankruptcy court to become aware of problems with the reorganization plan that had been confirmed only one month ago. Although the Board had not come to any firm conclusions regarding whether malpractice occurred at this time, Collins testified that the Board knew the numbers were flawed, "had some questions about whether the company got its money's worth for some of the professional fees," and held "very, very possible concerns . . . about whether there might have been a problem with the professional work." Instead of contesting the fees at the hearing on the basis of their quality, the Board decided, as Collins stated in his deposition, to use its concerns and suspicions as "a negotiating chip that we could have to get the fees reduced."

On January 17, 1995, Collins sent a memo to Stan Springel, a turnaround specialist for IT, expressing these concerns and the decision not to raise issues regarding the competency of the services provided by Ernst & Young and others. Collins's memo states in part:

"I would appreciate it if you would consider this matter and discuss as appropriate with Phil Freeman so Phil or you can to talk to Buccino and/or E+Y this week.

. . .

We now know the budget numbers were flawed in important respects. This led to a serious understatement of working capital requirements, the Board's recommendation that you be engaged and the unforeseen need for the collateral liquidation proceeds of $1.4 million to fund operations. These are serious ramifications.

There may be negative reaction on the part of the judge to the assertion that Buccino's shortcomings caused damage to the company. In this regard steps have been taken by management to preserve liquidity despite the problems brought on by Buccino's numbers; consequently there is a good argument that the problem has not had the effect of changing the company's 'fitness' for coming out of bankruptcy.

Ernst & Young; $218,980 - The Audit Committee of the Board has not yet had an opportunity to examine the performance of E+Y. I observe that the sudden deterioration of the company's financial position raises questions as to the veracity of E+Y's audited numbers at the very time the company is being asked to pay them $218,000 in fees. I understand that the fees may not be related to the audit, but in my mind this arrangement does not seem right and as in the case of Buccino I wonder if Phil's suggested adjustments go far enough."

Freeman implemented the Board's strategy of using concerns over the quality of the professional services to negotiate lower fees and reported in a January 18, 1995 memo to the Board that he was successful in reducing Ernst & Young's fees: "I am pleased to advise that we had negotiated a fee reduction with Ernst & Young of $37,000 from their fee application for $218,980. In return we will unqualifiedly support their fee application. I am awaiting responses from other fee applicants."

On January 23, 1995, the bankruptcy court held a hearing for all the service providers' fee applications. At the hearing, Freeman was present on behalf of IT and did not oppose Ernst & Young's application, subject to the $37,000 reduction. Following an examination of Tom Richter, a partner of Ernst & Young, the bankruptcy court found the fees to "have passed muster," without objection by Freeman. Two days later, the bankruptcy court approved an allowance of $180,237 for fees and $1,243 for expenses for Ernst & Young.

Despite the efforts of IT's management and its professional services providers, but consistent with the Board's above- mentioned concerns, IT's financial problems continued under the reorganization plan. On March 16, 1995, IT filed a second voluntary Chapter 11 petition. This second Chapter 11 proceeding was later converted into the instant Chapter 7 liquidation with Randolph N. Osherow appointed as trustee.

After Ernst & Young had filed in the instant bankruptcy a claim for the unpaid fee awarded it in the prior bankruptcy, the Trustee, on November 7, 1996, filed this suit against Ernst & Young in a Texas state court, alleging the following causes of action, all in respect to Ernst & Young's functioning as IT's accountant in the initial Chapter 11: (1) violation of the duty to exercise ordinary care and diligence; (2) negligence; (3) gross negligence; (4) professional negligence; (5) breach of warranty; (6) breach of contract; and (7) deceptive trade practices. The Trustee alleged that "EY [Ernst & Young] owed a duty to IT to perform all necessary and reasonable accounting services on behalf of IT as set forth in its application [referring to the application in the initial Chapter 11 for the bankruptcy court to approve IT's retaining of Ernst & Young "as accountant for the debtor in possession"] and EY failed in such duties and failed to provide the services as represented." The Trustee's particular focus was that Ernst & Young failed to adequately contact IT's customers respecting prepayment of contracts. This led to flaws in the construction of financial projections and an operating plan for IT, eventually resulting in IT's cash shortfall and collapse.

Pursuant to 28 U.S.C. 1452, Ernst & Young removed this case to the bankruptcy court supervising IT's Chapter 7 liquidation. Ernst & Young, subsequently moved for summary judgment on the basis that the Trustee's claims were barred by res judicata, collateral estoppel, or waiver. Concluding that the Trustee's claims were barred by res judicata, the bankruptcy court granted Ernst & Young's motion. The district court affirmed the bankruptcy court's order. In Re Intelogic Trace Inc., 226 B.R. 382 (W.D. Tex. 1998). We affirm.

DISCUSSION

The Trustee argues that the district court erred in affirming the bankruptcy court's summary judgment order finding res judicata barred this action. This Court reviews the grant of summary judgment de novo, applying the same standards as the district court. See Merritt-Campbell, Inc. v. RxP Prods., Inc., 164 F.3d 957, 961 (5th Cir. 1999). Summary judgment is proper only where, viewing the evidence in the light most favorable to the nonmoving party, the court determines that there is no genuine issue of material fact and judgment is proper as a matter of law. See id.; FED. R. CIV. P. 56(c).

This Circuit's test for determining whether a claim is barred by the doctrine of res judicata, or claim preclusion, is as follows:

"'For a prior judgment to bar an action on the basis of res judicata, the parties must be identical in both suits, the prior judgment must have been rendered by a court of competent jurisdiction, there must have a final judgment on the merits and the same cause of action must be involved in both cases.'" Nilsen v. City of Moss Point, Miss., ...