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In re CBI Holding Company

December 8, 2009



In 1996, Plaintiff Bankruptcy Services, Inc. ("Plaintiff") brought this action in the Bankruptcy Court of the Southern District of New York, on behalf of CBI Holding Company, Inc. and most of its subsidiaries (collectively, "CBI") and Trade Company of The West ("TCW"), an investor in CBI.*fn1 Plaintiff alleged that Defendant Ernst & Young ("E&Y") committed malpractice and fraud when it audited CBI's 1992 and 1993 financial statements.*fn2 In 2000, after a bench trial, the Bankruptcy Court granted judgment in favor of Plaintiff.*fn3 E&Y appealed the Bankruptcy Court's ruling to this Court. In 2004, the Court vacated the Bankruptcy Court's judgments.

BSI appealed the Court's ruling to the Second Circuit, and E&Y cross-appealed. In 2008, the Second Circuit affirmed the Court's decision in part, reversed in part, and remanded the case to the Court for proceedings in accordance with the Circuit's decision.

The Court must now decide three issues that E&Y raised on appeal with respect to the claims BSI asserted on behalf of CBI (the "CBI Claims")*fn4 that the Court did not decide in 2004, but which have become relevant again following the Second Circuit's decision: (1) whether the Bankruptcy Court had sufficient legal and factual basis for its ruling that E&Y committed malpractice and fraud; (2) whether there was sufficient evidence to support the Bankruptcy Court's ruling that E&Y's conduct caused CBI's losses; and (3) whether the Bankruptcy Court committed clear error in its determination of the damages E&Y owed on the CBI Claims.

The Court holds that: (1) the Bankruptcy Court had sufficient legal and factual basis for its finding that E&Y committed malpractice, but did not have a sufficient basis for its finding that E&Y committed fraud; (2) there was sufficient evidence on the record to support the Bankruptcy Court's ruling that E&Y's conduct caused injury to CBI; and (3) further proceedings are necessary in the Bankruptcy Court with respect to the damages awarded against E&Y. The judgment of the Bankruptcy Court is AFFIRMED in part, REVERSED in part, and REMANDED to the Bankruptcy Court for further proceedings in accordance with this decision.

I. Background*fn5

A. Parties

CBI was a wholesale distributor of pharmaceutical products. Its business consisted of buying pharmaceutical products from manufacturers, and warehousing them for delivery to various entities, including retail pharmacies and hospitals. In 1994, CBI filed for Chapter 11 bankruptcy.

Robert Castello ("Castello") was CBI's President and Chairman, and owned a 52% stake in the company.

TCW is an investment firm that held a 48% stake in CBI. E&Y is an accounting, tax, and consulting firm. E&Y became CBI's independent auditor in June 1990. E&Y performed audits of CBI's financial statements for fiscal years 1992 and 1993 (the "Audits"). In 1994, E&Y began a re-audit of CBI's 1993 financial statements (the "Re-Audit").

Louis Scerra ("Scerra") was E&Y's lead auditor for the Audits and the Re-Audit.

B. Facts

In the early 1990s, in order to stay competitive in its industry, CBI undertook a strategy of growth by acquisition. In 1992 and 1993, CBI financed the purchase of four other pharmaceutical wholesalers through a series of lending agreements with a bank syndicate, and through capital invested in CBI by TCW. CBI's shareholder agreement gave TCW the right to take control of CBI under certain circumstances.*fn6

1. CBI's fraud

Despite CBI's having received loans and investments, CBI's earnings were insufficient to sustain its desired level of borrowing. Castello and other members of CBI's management engaged in a scheme to falsely inflate the company's earnings for the 1992 and 1993 fiscal years.

The management's scheme consisted largely of inventory fraud. In particular, CBI's management intentionally failed to record some invoices during the fiscal year in which the goods associated with those invoices were either purchased or received.

By not recording liabilities, CBI's management understated CBI's accounts payable and fraudulently overstated the company's 1992 and 1993 earnings.

In order to continue to receive merchandise from vendors, CBI had to pay at least some of the unrecorded invoices during the fiscal year in question. To avoid raising questions about missing invoices (which might lead to the discovery of the unrecorded liabilities), CBI's management recorded the payments as "advances": payments made to vendors from whom CBI purchased on credit, which reduced CBI's overall account balances with those vendors. When an advance payment was recorded, it was not associated with any particular invoice.*fn7

In addition to the inventory fraud, Castello also defrauded CBI with regard to his annual bonuses -- among other actions, he took a portion of his 1993 bonus early and calculated his bonus based on falsely inflated earnings.

2. E&Y's 1992 and 1993 audits

E&Y issued unqualified audit opinions with respect to CBI's 1992 and 1993 financial statements. E&Y's opinions stated that E&Y conducted the Audits in accordance with Generally Accepted Accounting Standards ("GAAS") and that, in the opinion of E&Y, the consolidated financial statements presented fairly, in all material respects, the financial position of CBI. In fact, the financial statements did not fairly present CBI's financial condition, because E&Y failed to detect the disguised, unrecorded liabilities when it performed the Audits.

a. E&Y's preparation for the Audits

Prior to commencing each Audit, E&Y prepared a document entitled "Assessment of Control Environment." The document stated that: (1) CBI's management was dominated by its CEO and V.P. of Finance; (2) management's attitude toward valuing accounts was aggressive; (3) duties in the accounting department were not segregated; (4) the company's largest debt agreement included stringent financial convenience, which could influence management's philosophy and attitudes towards estimates; and (5) CBI had no internal audit function. The assessment also noted some positive factors about CBI's control environment. Overall, however, E&Y assessed CBI's control environment as "ineffective."

E&Y completed several other audit planning forms each year (the "Audit Plans"). The Audit Plans noted that CBI was a "close monitoring" engagement, meaning that there was a significant chance that E&Y would suffer monetary or reputational damage as a result of the Audits. The Audit Plans designated the CBI accounts payable department as "high risk."

E&Y's Audit Plans also laid out the steps E&Y planned to take with respect to auditing each area of CBI's operations. For the accounts payable department, the Audit Plans stated that, among other steps, E&Y would perform a search for unrecorded liabilities. A search for unrecorded liabilities involves reviewing records of all payments made by a company for a period of time after the end of the fiscal year, and, for all such payments made over a specified amount, examining corresponding documentation.

The purpose of a search for unrecorded liabilities is to determine whether or not the goods or services paid for were received as of the end of the fiscal year under audit. If the goods or services were received prior to year end, the auditor is required to ascertain whether the liability was properly recorded for that year. If liabilities are not properly recorded, the company's earnings will be falsely inflated.

The Audit Plans also stated that, during the Audits, E&Y would carry out "vendor reconciliations" for accounts payable. For this step, E&Y intended to obtain copies of vendor statements from the last date of the fiscal year for, in 1992, CBI's five largest vendors, and, in 1993, its 10 largest vendors. E&Y would then reconcile these statements against the account payable balances for those vendors, as recorded in CBI's books. The Bankruptcy Court found that at least one purpose of performing vendor reconciliations was to test for unrecorded liabilities.*fn8

b. Conducting the Audits

In 1992, the Audit detected $292,000 unrecorded liabilities on CBI's books, but failed to detect an additional $1.82 million of such liabilities. In 1993, the Audit found $1.4 million in unrecorded liabilities, but missed an additional $7.5 million.

In conducting the Audits, E&Y performed a search for unrecorded liabilities. During the searches, E&Y observed the advance payment notations in CBI's books. E&Y asked CBI's management for an explanation of the advance notations, and was told that these were payments made to reduce credit balances with vendors. E&Y did not take any independent steps to verify this explanation.*fn9

In addition, E&Y did not analyze advance payments during the search for unrecorded liabilities.*fn10 The Bankruptcy Court found that, if E&Y had analyzed the advance payments, it would have discovered the additional unrecorded liabilities.

With respect to vendor reconciliations, E&Y conducted reconciliations on five of CBI's vendors in 1992, and ten of its vendors in 1993, but not on its five and ten largest vendors, as E&Y had planned. The Bankruptcy Court found that if in 1993 E&Y had performed the vendor reconciliations as planned, it would have discovered additional unrecorded liabilities.

During the 1993 Audit, Scerra, E&Y's lead auditor, also learned that Castello had taken his bonus early and that his bonus was calculated based on of falsely inflated earnings.*fn11

Scerra did not include the bonus information in the 1993 Audit Report, however. On internal documents, Scerra noted that Castello placed "undue influence" on earnings, which he marked as a red flag.

c. Events following the 1993 Audit

In early November 1993, Steve Young ("Young"), who had been hired to be CBI's Chief Financial Officer, left the job after only eight days. Before leaving, Young alleged that there was $3-4 million of "grey accounting" on CBI's books. Scerra told Castello that he was interested in speaking with Young, but he did not actually do so until March 1994, at which point Young confirmed that CBI had $5-6 million of unrecorded liabilities at the end of the 1993 fiscal year (by March 1994, E&Y had also discovered these unrecorded liabilities).

During December 1993 and January 1994, E&Y had meetings to discuss whether it should continue its relationship with CBI. The E&Y partners in attendance, including Scerra, discussed a number of "red flags" with respect to CBI, including E&Y's evaluation that CBI's management placed undue influence on earnings, aggressive accounting at CBI, and Young's allegations. It was Scerra's opinion that the CBI engagement was too risky for E&Y, but E&Y decided to continue the engagement.

d. Discovery of the fraud

In early February 1994, the former controller of CBI's Granain subsidiary revealed to an E&Y auditor that there had been significant unrecorded liabilities at Granain, which had been disguised as "advances."

In response to the allegations, E&Y's auditing team for the Audits reviewed the work they had done during the 1993 search for unrecorded liabilities. They saw that E&Y had noted the advance payments but had not conducted the search for unrecorded liabilities on them. E&Y then began an investigation into the Granain allegations.

On March 8, 1994, while E&Y was investigating Granain, CBI's controller told Scerra that there were $6-7 million disguised, unrecorded liabilities at CBI. E&Y began a broader investigation and quickly uncovered $5 million in unrecorded liabilities.

On March 12, 1994, E&Y informed CBI's Board of Directors that E&Y had withdrawn its reports with respect to CBI's 1993 financial statements, and that the reports could no longer be relied upon.

Following the revelation of the unrecorded liabilities, TCW exercised its right to take control of CBI. Castello remained at CBI as Chief Operating Officer, but a TCW official, Frank Pados ("Pados") was brought in to oversee the company. TCW hired E&Y to conduct the Re-Audit. When E&Y accepted the assignment, it did not inform TCW that its auditors had noted the advance payments during the 1993 Audit, but had not analyzed them during the search for unrecorded liabilities.

e. CBI's Bankruptcy

While E&Y was conducting the Re-Audit, CBI's financial situation began to worsen. In the spring of 1994, CBI sought a recapitalization from its bank syndicate. One bank in the syndicate would not commit to the recapitalization. In the meantime, CBI began having trouble making timely payments to its vendors. In turn, CBI's vendors began tightening their credit terms with CBI and reducing shipments. As a result, CBI's inventory shrank, it had trouble filling orders, and its customers began moving to other suppliers. This further reduced CBI's cash flow and made it even harder for the company to make payments to vendors. CBI's financial situation began to spiral downward.

In June 1994, FoxMeyer, a company engaged in the wholesale pharmaceutical business, indicated that it was interested in purchasing CBI. FoxMeyer estimated that CBI was worth $142 million. FoxMeyer withdrew its proposal later that month.

In July 1994, Pados informed E&Y that it could cease the Re-Audit, because CBI was on the verge of collapse. Later that month, ...

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