In re Cbi Holding Co., Inc.

• Decision Date: 16 June 2008
• Docket Number: Docket No. 04-5972-bk(L).,Docket No. 04-6300-bk(XAP).
• Citation: 529 F.3d 432
• Parties: In re CBI HOLDING COMPANY, INC., Debtor, Bankruptcy Services, Inc., Plaintiff-Appellant-Cross-Appellee, v. Ernst & Young, Ernst & Young LLP, Defendants-Appellees-Cross-Appellants.
• Court: U.S. Court of Appeals — Second Circuit

529 F.3d 432

In re CBI HOLDING COMPANY, INC., Debtor Bankruptcy Services, Inc., Plaintiff-Appellant-Cross-Appellee, v. Ernst & Young, Ernst & Young LLP, Defendants-Appellees-Cross-Appellants.

Docket No. 04-5972-bk(L).

Docket No. 04-6300-bk(XAP).

United States Court of Appeals, Second Circuit.

Argued: September 19, 2005.

Decided: June 16, 2008.

Jay G. Strum, Kaye Scholer LLP (Arthur Steinberg, Robert B. Bernstein, Elisabeth C. Kann, on the brief), New York, NY, for Plaintiff-Appellant-Cross-Appellee.

Andrew L. Frey, Mayer, Brown, Rowe & Maw LLP (Sandford I. Weisburst, Mayer, Brown, Rowe & Maw LLP; Richard F. Broude, P.C.; and Irwin J. Sugarman, Harry S. Davis, Schulte Roth & Zabel LLP, on the brief), for Defendants-Appellees-Cross-Appellants.

Before WINTER, SOTOMAYOR, and WESLEY, Circuit Judges.

WESLEY, Circuit Judge:

In August 1994, CBI Holding Company, Inc. and all but one of its subsidiaries (collectively, "CBI") filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. Ernst & Young and Ernst & Young LLP (together, "E & Y"), the pre-bankruptcy accountants for CBI and Defendants-Appellees in this action, filed a Proof of Claim against CBI in those proceedings for allegedly unpaid auditing and consulting services. On August 23, 1995, the United States Bankruptcy Court for the Southern District of New York (Lifland, J.) confirmed a Plan of Reorganization ("the Plan") and appointed Bankruptcy Services, Inc. ("BSI"), the Plaintiff-Appellant in this action, the disbursing agent of the Plan. On October 16, 1996, BSI filed a complaint in the bankruptcy court, followed by an amended report on October 25, 1996, pressing seven claims against E & Y concerning the professional services E & Y rendered to CBI from 1992 to 1994. BSI brought each of the seven claims as the successor to the claims of CBI under the Plan (collectively, "the CBI claims"). Pursuant to a settlement contained in the Plan, BSI also brought four of these claims as the assignee of the claims that Trust Company of the West ("TCW") acquired as a pre-bankruptcy creditor of CBI (collectively, "the TCW claims"). Finally, BSI also brought one claim — for expungement of E & Y's Proof of Claim — as the assignee of an objection to E & Y's Proof of Claim filed by the Official Unsecured Creditors' Committee ("Creditors' Committee"). On April 5, 2000, the bankruptcy court granted judgment for BSI on six of its seven claims, see Bankr. Servs., Inc. v. Ernst & Young (In re CBI Holding Co.), ("CBI I" or "Bankruptcy Opinion"), 247 B.R. 341 (Bankr. S.D.N.Y.2000), and later awarded BSI approximately $70 million in damages. In two orders entered on June 30, 2004, see Ernst & Young v. Bankr. Servs., Inc. (In re CBI Holding Co.) ("CBI II" or "June Order"), 311 B.R. 350 (S.D.N.Y.2004), and October 25, 2004, see Ernst & Young v. Bankr. Servs., Inc. (In re CBI Holding Co.) ("CBI III" or "October Order"), 318 B.R. 761 (S.D.N.Y.2004), the United States District Court for the Southern District of New York (Wood, J.)¹ vacated the judgment of the bankruptcy court, and directed judgment in E & Y's favor, on the grounds that: (1) the fraudulent acts of CBI's management must be imputed to the company itself, thereby depriving BSI of standing to press the CBI claims; and (2) BSI lacks standing to assert the TCW claims under Barnes v. Schatzkin, 215 A.D. 10, 212 N.Y.S. 536 (1st Dep't 1925). BSI appeals from each of these grounds. We agree and reverse.

We hold that BSI has standing to assert the CBI claims under the so-called "adverse interest" exception to the normal rule that a claim against a third party for defrauding a corporation with the cooperation of its management accrues to creditors rather than to the guilty corporation. The bankruptcy court's finding that CBI's management "was acting for its own interest and not that of CBI" is not clearly erroneous and constitutes the "total abandonment" of a corporation's interests necessary to satisfy the adverse interest exception. We also hold that BSI has standing to assert the TCW claims because revisions to the bankruptcy laws have undermined the rationale of Barnes for the reasons set forth in Semi-Tech Litigation, L.L.C. v. Ting, 13 A.D.3d 185, 787 N.Y.S.2d 234 (1st Dep't 2004).

Because we reverse, we must reach the two arguments that E & Y raises in its cross-appeal: (1) BSI's claims are not "core proceedings" that may be adjudicated by a bankruptcy judge; and (2) E & Y is entitled to a jury trial on all of BSI's claims. We reject both arguments. We hold that all of the claims pressed by BSI — both the CBI claims and the TCW claims — are "core proceedings," because they are covered by the language of 28 U.S.C. § 157(b) and are integrally related to the Proof of Claim that E & Y voluntarily submitted against the estate. Similarly, we hold that while both parties now agree that E & Y is entitled to a jury trial on the TCW claims, E & Y waived its right to a jury trial on the CBI claims when it submitted its Proof of Claim against the estate and subjected itself to the equitable powers of the bankruptcy court. Moreover, under the rule announced by the Supreme Court in Katchen v. Landy, 382 U.S. 323, 86 S.Ct. 467, 15 L.Ed.2d 391 (1966), there is no need to vacate the portions of the bankruptcy court's judgment which relate to the CBI claims merely because the portions of the judgment which relate to the TCW claims have been vacated to allow for a jury trial.

BACKGROUND

I.²

The parties. CBI was a large wholesale distributor of pharmaceutical products. Its business consisted primarily of purchasing pharmaceutical products from manufacturers and warehousing those products for delivery to entities such as retail pharmacies and hospitals, which in turn sold the products to end users. CBI's President and Chairman was Robert Castello. Castello had an employment agreement with CBI in which he was eligible for an annual bonus in an amount tied to the company's net earnings.

To remain competitive, CBI undertook in the early 1990s a strategy of growth by acquisition. It financed these acquisitions in two ways. First, it borrowed capital from a bank syndicate through a series of lending agreements. These agreements included specific financial targets — including an earnings to fixed charge ratio, a net worth ratio and other standard covenants — that CBI had to meet in order to be eligible for additional credit and to avoid default on its existing loans. Moreover, the agreements limited the credit available to each subsidiary of CBI in terms of actual dollars and as a fixed percentage of inventory and accounts receivable. To monitor attainment of the specified targets, the banks required CBI to provide an array of monthly, quarterly, semiannual and annual reports detailing the company's earnings, inventory and receivables, and to certify in connection therewith its compliance with the agreements' various covenants. Second, it acquired capital from TCW, which invested in CBI in May 1991 and again in April 1993. In May 1991, TCW invested $20 million in exchange for $5 million in CBI common stock and $15 million in corporate notes. As a result of this investment, TCW acquired 48% of CBI, while Castello retained 52% of the company. In April 1993, TCW invested an additional $750,000 in CBI in exchange for a note with a face value of $750,000 and $250,000 worth of CBI common stock.

Through its initial investment, TCW also acquired various rights set forth in a shareholders agreement (the "Shareholders Agreement") and a securities purchase agreement (the "Securities Agreement"). Most importantly, TCW acquired 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, while Castello retained the Presidency and Chairmanship of CBI as well as the right to select the Board's and Audit Committee's remaining members. TCW's two seats on the Board were filled by Frank Pados and, by 1993, Brian Mahoney.

TCW also acquired 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 the principal on TCW's corporate notes, whether such payment was due at maturity or by reason of acceleration. The Securities Agreement permitted TCW to accelerate CBI's note payment schedule in the event of certain defaults, including the making of any unauthorized loan to a CBI officer (e.g., Castello).

E & Y became CBI's independent auditors in June 1990. E & Y performed audits of CBI's financial statements for fiscal years 1990 to 1993, and in 1994 began a re-audit of CBI's 1993 financial statements. In addition to serving as independent auditors, E & Y also received substantial fees for performing supplemental mid-year reviews and due diligence procedures related to CBI's acquisitions.

The fraud. It is undisputed that Castello and certain other members of CBI's management engaged in a scheme to deceive the company's lenders, including TCW, as to CBI's true financial condition during fiscal years 1992 and 1993. The fraudulent scheme consisted primarily of inventory fraud, which took three principal forms.

First, CBI's management delayed the recording of invoices — that is, CBI's management intentionally failed to record invoices during the fiscal year in which purchases were made and/or goods were received. Since CBI had to continue to pay its vendors in order to continue to receive merchandise, management would round up the amounts owed as payments to the vendors and classify the amounts paid as "advance" payments. Advance payments are usually considered assets and recorded as such on the balance sheet, but E & Y's work papers indicate that the advance payments were treated as reductions to "accounts payable." Because the invoices were never...