In re CBI Holding Co., Inc.
| Decision Date | 30 June 2004 |
| Docket Number | Bankruptcy No. 94-B-438129(BRL). No. 01-CIV-0131 (KMW). |
| Citation | 311 B.R. 350 |
| Parties | In re CBI HOLDING COMPANY, INC., et al., Debtors, Ernst & Young and Ernst & Young, LLP, Appellants, v. Bankruptcy Services, Inc., Appellee. |
| Court | U.S. District Court — Southern District of New York |
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Andrew L. Frey, Mayer, Brown, Rowe & Maw LLP, David Michael Hillman, Mayer, Brown, Rowe & Piatt, Harry Simeon Davis, Schulte, Roth & Zabel LLP, New York City, for Ernst & Young, Ernst & Young LLP.
Arthur Steinberg, Robert B. Bernstein, Jay G. Strum, Kaye, Scholer, Fierman, Hays & Handler, LLP, New York City, for Bankruptcy Services, Inc.
Ernst & Young and Ernst & Young, LLP (collectively, "Ernst & Young") appeal from a judgment of the United States Bankruptcy Court (Burton R. Lifland, Judge) in an adversary proceeding. The bankruptcy court found Ernst & Young liable for breach of contract, negligence, negligent misrepresentation and fraud in connection with Ernst & Young's pre-petition auditing of the financial statements of a company that petitioned for bankruptcy. The bankruptcy court entered judgment against Ernst & Young for approximately $70 million, and expunged Ernst & Young's $210,850 Proof of Claim against the company.
For the reasons set forth below, the Court affirms in part and reverses in part the decision of the bankruptcy court. The Court does not now remand this action to the bankruptcy court, but rather orders the parties to submit additional briefing.
The following facts are derived from the bankruptcy court's April 5, 2000 decision regarding liability, see In re CBI Holding Co., 247 B.R. 341, 364-65 (Bankr.S.D.N.Y. 2000), and from the record on appeal. The Court takes from the record on appeal only those facts that are consistent with the bankruptcy court's findings and that are uncontested by the parties.
Prior to bankruptcy, CBI Holding Company, Inc., in conjunction with its subsidiaries (collectively, "CBI" or "Debtors"), was a large wholesale distributor of pharmaceutical products. As a wholesale distributor, CBI's business was to purchase pharmaceutical products from manufacturers, and warehouse those products for delivery to entities such as retail pharmacies and hospitals. CBI achieved its size during the early 1990s by pursuing a strategy of growth through acquisition. CBI financed its acquisitions in two ways.
First, CBI borrowed capital from a bank syndicate through a series of lending agreements. The lending agreements limited the amount of money that CBI could borrow, based on a formula dependent upon the inventory and accounts receivable of each CBI subsidiary. The greater the inventory and accounts receivable that conformed to certain eligibility requirements, the more CBI could borrow, up to specified limits. The lenders ensured CBI's compliance with the limitations in the lending agreements by requiring CBI to submit periodic reports detailing earnings, inventory, and receivables.
Second, CBI acquired capital from Trust Company of the West ("TCW"), which invested in CBI in May 1991 and again in April 1993. In May 1991, TCW invested $20 million in CBI, and received in return $5 million in shares of CBI common stock (48% of all shares) and $15 million in corporate notes. In April 1993, TCW invested an additional $750,000 in CBI, and received a note with a face value in that amount, plus $250,000 worth of shares of common stock.
As a result of the May 1991 investment, TCW acquired various rights, which are set forth in a shareholders agreement dated May 31, 1991 (the "Shareholders Agreement"), and a securities purchase agreement dated May 13, 1991 (the "Securities Agreement"). Pursuant to the Shareholders Agreement, TCW had the right to select two of the five members of CBI's board of directors and one of the three members of the board's audit committee. CBI's president and CEO, Robert Castello ("Castello"), held the remaining 52% of shares of CBI common stock. With that share of ownership, Castello had the right to select the remaining members of the board of directors and the audit committee. TCW also received certain contingent rights to take control of CBI. Pursuant to the Shareholders Agreement, TCW had the right to take control of CBI in the event of the occurrence of a "control triggering event." The Shareholders Agreement defined control triggering events to include (1) a breach of the earnings to fixed charge ratio specified in the Securities Agreement, and (2) a failure to pay principal on TCW's corporate notes, whether such payment was due at maturity or by reason of acceleration. TCW had the right to accelerate payment on its notes, pursuant to the Securities Agreement, in the event of a failure by CBI to comply in any material respect with certain covenants in the Securities Agreement. Those covenants established the earnings to fixed charge ratio and included a prohibition against certain transactions, including loans to CBI's officers.
The compensation agreement between Castello and CBI provided for a bonus payment for Castello that was tied to CBI's earnings. Castello received a bonus for fiscal year 1992 that was tied to fiscal year 1992 earnings. Castello also caused a portion of his bonus for fiscal year 1993 to be paid to him before it was due.
In fiscal years 1992 and 1993, CBI's management, including Castello, participated in the misrepresentation of CBI's inventory, the misrepresentation of the age of certain of CBI's receivables, and the intentional failure to record certain of CBI's liabilities.
Ernst & Young was the pre-bankruptcy accounting firm for Debtors. Ernst & Young issued unqualified audit opinions with respect to Debtors' financial statements for fiscal years 1992 and 1993. Ernst & Young issued its fiscal year 1992 opinion on August 6, 1992, and its fiscal year 1993 opinion on October 26, 1993. For each of those years, Ernst & Young's opinions stated, inter alia, that Ernst & Young conducted its audit in accordance with Generally Accepted Accounting Standards ("GAAS") and that, in the opinion of Ernst & Young, the consolidated financial statements presented fairly, in all material respects, the financial position of Debtors. In actual fact, the financial statements prepared by Ernst & Young did not present fairly, in all material respects, the financial position of Debtors because Ernst & Young did not detect certain unrecorded liabilities when it performed the fiscal 1992 and 1993 audits. In March 1994, Ernst & Young acknowledged that Debtors' 1993 financial statements were materially inaccurate and withdrew its October 23, 1993 opinion. Also in March 1994, Ernst & Young commenced additional procedures related to the financial statements of CBI for fiscal year 1993 (the "re-audit"). Ernst & Young never completed the re-audit because, in July 1994, CBI directed it to cease all audit-related activities.
In August 1994, Debtors filed a petition for relief under Chapter 11 of the Bankruptcy Code. In January 1995, Ernst & Young filed a Proof of Claim against CBI in those proceedings in the amount of $210,850 for allegedly unpaid auditing and consulting services (the "Proof of Claim"). The Proof of Claim states that the claim "arises from professional services rendered in 1993 and 1994 on behalf of Debtor in connection with the audit of Debtor's financial statements and other special engagements as described in the attached Exhibits." (RE 780).1 Those Exhibits are seven invoices dated between May 12, 1994 and August 5, 1994. In June 1995, the Official Committee of Unsecured Creditors of Debtors (the "Creditors' Committee") filed an objection to certain claims filed in Debtors' bankruptcy action, including the claim filed by Ernst & Young. The objection does not allege malpractice but states that it is "without prejudice to the Committee's right to object to the within proofs of claim on other grounds as may be necessary." (Affirmation of Michael L. Schein, dated October 17, 1996 (filed in 96 Civ. 7969) Ex. E, at 9).
By order dated August 23, 1995, the bankruptcy court confirmed the First Amended Joint Plan of Reorganization of Creditors' Committee and Debtors (the "Plan"). In that order, the bankruptcy court appointed Bankruptcy Services, Inc. ("BSI"), the appellee in this action, as the disbursing agent of the Plan. The Plan "provides for the liquidation of all of the Debtors' Assets and the prosecution of various litigations on behalf of the Debtors against third parties (other than the TCW Entities) and the distribution of the net proceeds thereof to the holders of Allowed Claims in accordance with applicable bankruptcy law and this Plan." (RE 795). Under the Plan, Debtors granted to BSI, inter alia, "the right to pursue and prosecute... all adversary proceedings and contested matters pending or thereafter commenced or filed in the Bankruptcy Court or elsewhere, including ... any and all objections to claims." (RE 798). The Plan also provided that Debtors "shall be deemed to have waived and released any and all claims ... against TCW," and that TCW "shall receive an allowed claim of $16.7 million," and shall "be deemed to have transferred and assigned to the Disbursing Agent, any and all rights to pursue and prosecute causes of action of any kind held by TCW against any third party, in its capacity as a Creditor or equity security holder of any of the Debtors." (RE 798a).
On October 16, 1996, BSI, in its capacity as the Disbursing Agent under the Plan, filed a complaint in bankruptcy court against Ernst & Young (the "Adversary Proceeding"). On October 25, 1996, the Creditors' Committee and BSI entered into an assignment under which the Creditors' Committee expressly assigned to BSI its "right, title...
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