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June 26, 2004.

In re CBI HOLDING COMPANY, INC., et al., Chapter 11, Debtors. ERNST & YOUNG and ERNST & YOUNG, LLP, Appellants,

The opinion of the court was delivered by: KIMBA WOOD, District Judge


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. I. Factual Background

  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.

  II. Procedural History

  A. The Bankruptcy Proceeding

  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).*fn1 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).

  B. The Adversary Proceeding

  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 and interest to pursue and prosecute all adversary proceedings and contested matters pending as of the Effective Date of the Plan or thereafter commenced or filed in the Bankruptcy Court or elsewhere including, without limitation, the Litigations and objections to claims, inclusive of the Objection to the claim of [Ernst & Young]."

  On or about October 25, 1996, BSI filed an amended complaint, alleging the assignment of Debtors' and TCW's claims against Ernst & Young, and the assignment of the Creditors' Committee's Objection to Ernst & Young's Proof of Claim. The amended complaint concerns professional services rendered by Ernst & Young to Debtors from 1992 to 1994. Specifically, BSI alleges: (1) breach of contract in connection with the fiscal 1992 and 1993 audits; (2) negligence in connection with the fiscal 1992 and 1993 audits; (3) negligent misrepresentation that the fiscal year 1992 and 1993 financial statements were materially accurate and that Ernst & Young conducted the fiscal 1992 and 1993 audits in compliance with GAAS; (4) fraud and/or recklessness in connection with the fiscal 1992 and 1993 audits; (5) fraud and/or recklessness in inducing Debtors to retain Ernst & Young to perform the reaudit; (6) breach of fiduciary duty in failing to make certain disclosures to CBI; and (7) expungement of Ernst & Young's $210,850 Proof of Claim. BSI brought each of these claims as assignee of the claims of Debtors. Had CBI not filed for bankruptcy, the claims of Debtors would belong to Castello (52% shareholder) and to TCW as an equity holder in CBI (48% shareholder). The Court refers to these claims as "CBI's claims." The second, third, fourth, and fifth claims are also brought by BSI as assignee of the claims of TCW as a creditor of CBI. The Court refers to these claims as "TCW's claims." The bankruptcy court dismissed the breach of fiduciary duty claim by order dated April 21, 1999.

  In the amended complaint, BSI alleges damages to CBI in the form of expenditures that would not have been made but for Ernst & Young's misconduct (e.g., Castello's bonuses and base salary, fees for certain acquisitions, and fees paid to Ernst & Young), the loss of Debtors' value as a going concern, and increased losses and/or liabilities incurred after fiscal year 1992. BSI alleges damages to TCW representing TCW's loss with respect to its equity interest in Debtors and its loss with respect to its $15 million note.

  Soon after the filing of BSI's amended complaint, Ernst & Young moved to withdraw the Adversary Proceeding from bankruptcy court to this Court. By order dated November 13, 1998 (the "1998 Order", the Court denied that motion, concluding that the Adversary Proceeding qualified as a "core" proceeding under 28 U.S.C. § 157(b)(2), and specifically as a "counterclaim" under § 157(b) 2) (C) and as a proceeding concerning the "allowance or disallowance of claims against the estate" under § 157(b)(2) (B).*fn2 See 1998 Order, 6-10. The Court based that conclusion on its determination that the Proof of Claim and the claims in the amended complaint "are related, arise out of the same transaction, and a determination of [BSI's] claims would likely be dispositive of [Ernst & Young's] claims." Id. at 7. The Court also held that the interests of judicial economy would be best served by leaving the adversary proceeding in the bankruptcy court, given Judge Lifland's familiarity with the issues and the parties. See id. at 11-12.

  In December 1998, Ernst & Young moved for reargument and reconsideration of the 1998 Order. While that motion was pending, two other orders relevant to this appeal were issued. First, the bankruptcy court issued an order in May 1999 that, inter alia, bifurcated the trial on liability from the determination of damages. Second, in June 1999, Judge Baer, acting in Part I on an application by Ernst & Young, issued an order to show cause that the reference to bankruptcy court for purposes of trial should not be withdrawn. By order dated July 1, 1999, this Court vacated the order to show cause and stated that it would consider Ernst & Young's arguments in support of the order to show cause in conjunction with Ernst & Young's motion for reconsideration.

  The Court denied Ernst & Young's motion for reconsideration, by order dated August 13, 1999 (the "1999 Order"). In the 1999 Order, the Court rejected Ernst & Young's argument that the bankruptcy court could not properly hear the claims between TCW and Ernst & Young because they are two, non-debtor, third parties. See 1999 Order, 3-4. The Court determined that, because all of the claims asserted by BSI, including those assigned to it by TCW, involved Debtors or Debtors' property, those claims were properly deemed to be core. See id. The Court also affirmed its earlier finding, made in the 1998 Order, that BSI's claims constitute counterclaims to Ernst & Young's Proof of Claim, and rejected Ernst & Young's claim that the Creditors' Committee's assignment was ineffective. Id. at 4-5. Finally, the Court concluded that, to the extent the parties were protected by the Seventh Amendment, the bankruptcy court could conduct a jury trial without the consent of the partes. Id. at 6-10. The Court did not rule on whether CBI's claims could be tried without a jury.

  By order dated September 3, 1999, the bankruptcy court struck Ernst & Young's jury trial demand, finding that Ernst & Young had no right to a jury trial.

  After a bench trial on the issue of liability, the bankruptcy court issued its April 5, 2000 decision and granted "judgment" for CBI "on all remaining counts." In re CBI Holding, 247 B.R. at 369. The bankruptcy court did not discuss separately each of CBI's six claims and each of TCW's four claims, but instead stated the following conclusions: (1) Ernst & Young departed from GAAS in conducting the fiscal year 1992 and 1993 audits of Debtors' financial statements; (2) Ernst & Young's departure from GAAS was the proximate cause of injury to CBI and TCW; (3) the fact that the accounting fraud was known by Castello and other management employees does not deprive CBI (and BSI acting on CBI's behalf) of standing to assert its claims of auditor malpractice; (4) TCW (and BSI acting on TCW's behalf) has standing to assert both negligence and fraud claims against Ernst & Young; and (5) TCW's claims are not barred by New York General Obligation Law section 15-108(c). In its April 5, 2000 decision, the bankruptcy court did not state any specific conclusion with respect to BSI's claim for expungement of Ernst & Young's Proof of Claim.

  By order dated April 18, 2000, the bankruptcy court stated specifically that it had found Ernst & Young liable to BSI on BSI's first through fifth claims, and scheduled trial on damages. After a second bench trial, the bankruptcy court determined damages of $27,738,603, plus pre-judgment interest of over $17,000,000, with respect to the claims brought by BSI on behalf of CBI, and damages of $15,412,000, plus pre-judgment interest of nearly $10,000,000, with respect to the claims brought by BSI on behalf of TCW. The bankruptcy court found that the appropriate measure of damages suffered by CBI is the difference in the amount for which CBI's equity could have been sold in 1993 and $0 (CBI's value at the time the Plan was entered on August 23, 1995). The bankruptcy court found that the appropriate measure of damages suffered by TCW is the amount TCW would have received on its $15.75 million in notes if CBI had been sold in October 1993. The bankruptcy court thus awarded damages to TCW only as a creditor and not as an equity security holder of CBI.

  In its final judgment in this action, dated November 6, 2000, the bankruptcy court stated that, in its April 5, 2000 decision, it "found [Ernst & Young] liable to [BSI] on each of Counts I through V and found that with respect to Count VII that [sic] [Ernst & Young's] proof of claim in the bankruptcy proceeding in the amount of $210,850 should be expunged." The bankruptcy court again did not explain its reasons for expunging the Proof of Claim.

  Ernst & Young now appeals the bankruptcy court's decisions concerning liability and damages.

  III. Discussion

  In exercising appellate jurisdiction, a district court reviews the bankruptcy court's findings of fact for clear error, and its conclusions of law de novo. A court reviews mixed questions of fact and law de novo. See In re Vebeliunas, 332 F.3d 85, 90 (2d Cir. 2003); In re AroChem Corp., 176 F.3d 610, 620 (2d Cir. 1999).

  Ernst & Young raises seven arguments on appeal. First, it renews its argument that BSI's claims are not "core" and thus were not properly within the jurisdiction of the bankruptcy court. Second, it argues that it is constitutionally entitled to a jury trial on BSI's claims against it and that the bankruptcy court improperly struck Ernst & Young's jury trial demand Third, it contends that the bankruptcy court erred in refusing to impute the wrongdoing of CBI's senior management to CBI. Fourth, it asserts that the bankruptcy court erred in finding that Ernst & Young's alleged malpractice was the legal cause of CBI's and TCW's asserted injuries. Fifth, it challenges the bankruptcy court's findings of negligence and fraud. Sixth, it argues that TCW's ...

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