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February 27, 1996


The opinion of the court was delivered by: SCHEINDLIN



 In early 1989, the Koenig Corporation sought to acquire the assets of Eastern Artists and Drafting Materials, Inc. After some negotiation, the Koenig Corporation agreed to purchase Eastern's assets on a part cash, part credit basis. In March 1991, before all the payments were made, the Koenig Corporation filed for bankruptcy under Chapter 11 of the Bankruptcy Code.

 Plaintiffs Stanley Cohen ("Cohen"), Gerald Garfinkle ("Garfinkle") and Eastern Artists and Drafting Materials, Inc. ("Eastern") are now suing Elliott and Robert Koenig, the principals of the Koenig Corporation, alleging fraud in connection with the Koenigs' purchase of the assets of Eastern. Plaintiffs allege that the Koenigs made fraudulent misrepresentations in two respects: First, that the Koenig Corporation's financial statement was certified and set forth a true and accurate depiction of the sound financial condition of the Koenig Corporation. Cohen v. Koenig, 25 F.3d 1168, 1170 (2d Cir. 1994) (quoting the Amended Complaint P 24). Second, that the Koenig Corporation's "financial condition had substantially improved for the year since the last period covered by the financial statement," and that specifically its "net income would be substantially greater for the year about to end on June 30, 1989." Id.

 The Court held a bench trial from December 12 to December 21, 1995, from which the following findings of fact and conclusions of law are made.


 A. The Sale and Purchase of Eastern

 Defendants Robert and Elliott Koenig were officers, directors, controlling shareholders and employees of the Koenig Corporation. *fn1" Since 1933, the Koenig Corporation had been in the business of selling and distributing artist and drafting supplies and materials, both at wholesale to its franchisees and at retail through company-owned stores. By all accounts, the Koenig Corporation was one of the largest and most successful art supply businesses in the United States. In 1981, the Koenig Corporation owned just nine art supply stores, when then President Elliott Koenig decided to begin franchising. By 1990, the Corporation had roughly 125 stores (including both company-owned and franchised stores), whose estimated $ 100,000,000 combined business represented approximately 10% of the total art supply industry in the country.

 Prior to June 1, 1989, Plaintiffs Cohen and Garfinkle were the sole officers, directors and shareholders of Plaintiff Eastern, a company similarly engaged in the business of selling artist and drafting supplies. Eastern owned one store, located in midtown Manhattan, which enjoyed an average of approximately $ 5 million in net sales over the previous two years.

 In February 1989, Tony Parete, a representative of the Koenig Corporation, contacted Cohen and Garfinkle to inquire about the possibility of purchasing the assets of Eastern. Parete explained to Cohen and Garfinkle that the Koenig Corporation specifically wanted to establish a base of operations in New York City. For despite having stores in a number of major metropolitan areas, such as Philadelphia and Chicago, the Koenig Corporation neither owned nor franchised a store in New York City at that time.

 On February 24, 1989, Plaintiffs met with Robert Koenig and Tony Parete at Eastern's office. At that meeting, Robert Koenig proposed that the Koenig Corporation acquire Eastern's assets. *fn2" Robert Koenig explained the Koenig Corporation's plans to make a public offering, and reiterated the company's view that a New York location was critical to its future success.

 Sometime after the February meeting, the Koenig Corporation sent Plaintiffs its most recent certified financial statement, covering the fiscal year ending June 30, 1988 ("Financial Statement"). Among other things, the Financial Statement reported that the Koenig Corporation's net income for the fiscal year ending June 30, 1988 was $ 1,035,139. The Plaintiffs carefully reviewed the Financial Statement. *fn3"

 The parties held subsequent meetings on April 1, April 10, and May 17 to further discuss the proposed purchase of Eastern's assets. At each of these meetings, one or both of the Koenigs boasted of the Corporation's improving sales and recent acquisitions, and asserted that the acquisition of Eastern would solidify its position as the largest American company in the field of artist and drafting supplies and materials.

 On June 1, 1989, the purchase was completed after the final issue -- the personal guarantee from the Koenigs -- was resolved. Cohen and Garfinkle agreed to abandon their demand, in part due to the strength of the Financial Statement and in part because of the Koenigs' individual reputations in the art supply industry. As provided by the Agreement Of Sale, the Koenig Corporation made an initial cash payment of $ 1,550,000 at the closing (Ex. 1). In addition, each Plaintiff received $ 150,000 at closing in return for a five-year covenant not to compete ("Covenants") (Ex. 1). *fn4" Thus, as agreed, $ 1,850,000 was paid to Plaintiffs at the closing. The Koenig Corporation also agreed to repay a number of loans made to Eastern by Cohen and Garfinkle over the years totalling $ 644,000, to be paid in monthly installments over four years at a rate of 7.7% interest compounded annually (computing to $ 7,815.70 monthly and totalling $ 750,000) ("the Promissory Note") (Exs. 2,3,4,5). Finally, to account for the remaining sum, the Koenig Corporation agreed to pay $ 31,250 annually each to Cohen and Garfinkle for four-year consulting contracts (totalling $ 250,000) ("Consulting Agreements"). This final piece of the transaction price was structured in this way specifically to reduce the income tax liability of the Plaintiffs.

 B. The Errors in the Financial Statement

 Approximately one year later, in June, 1990, Koenig Corporation Chief Financial Officer David Geller ("Geller") began to suspect that the Fiscal Year 1988 financial statement was incorrect, due to a wide disparity in profit from the previous year. *fn5" Geller believed there may have been two errors in the Financial Statement. The first involved the valuation of inventory purchased in 1987 as part of the acquisition of an art supply store chain. The second involved the proper method of allocating costs when reacquiring a store from a former franchisee.

 1. The "Favor Ruhl" Acquisition and the Valuation of Inventory

 Favor Ruhl was a chain of art supply stores centered in Chicago, Illinois. *fn6" In early 1987, Koenig acquired the assets of Favor Ruhl from Robsac Industries, which was then in bankruptcy, for approximately $ 2.4 million. The ...

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