Chapter: Knapp Cases CBI Holding Company, Inc. Book Title: Fraud Examination Printed By: Abdullah Aljammaz (firstname.lastname@example.org) © 2019 Cengage Learning, Inc.
CBI Holding Company, Inc. During the 1980s, CBI Holding Company, Inc., a New York-based firm, served as the parent company for several wholly-owned subsidiaries, principal among them Common Brothers, Inc. CBI’s subsidiaries marketed an extensive line of pharmaceutical products. The subsidiaries purchased these products from drug manufacturers, warehoused them in storage facilities, and then resold them to retail pharmacies, hospitals, long-term care facilities, and related entities. CBI’s principal market area stretched from the northeastern United States into the upper Midwest.
In 1991, Robert Castello, CBI’s president and chairman of the board, sold a 48 percent ownership interest in his company to Trust Company of the West (TCW), a diversified investment firm. The purchase agreement between the two parties gave TCW the right to appoint two members of CBI’s board; Castello retained the right to appoint the three remaining board members. The purchase agreement also identified several so-called “control-triggering events.” If any one of these events occurred, TCW would have the right to take control of CBI. Examples of control-triggering events included CBI’s failure to maintain certain financial ratios at a specified level and unauthorized loans to Castello and other CBI executives.
Castello engaged Ernst & Young (E&Y) as CBI’s independent audit firm several months before he closed the TCW deal. During this same time frame, Castello was named “Entrepreneur of the Year” in an annual nationwide promotion co-sponsored by E&Y. From 1990 through 1993, E&Y issued unqualified opinions on CBI’s annual financial statements.
Castello instructed several of his subordinates to misrepresent CBI’s reported operating results and financial condition for the fiscal years ended April 30, 1992, and 1993. Those misrepresentations allowed Castello to receive large, year-end bonuses to which he was not entitled. CBI actively concealed the fraudulent activities from TCW’s management, from TCW’s appointees to CBI’s board, and from the company’s E&Y auditors because Castello realized that the scheme, if discovered, would qualify as a control-triggering event under the terms of the 1991 purchase agreement with TCW. Several years later in a lawsuit prompted by Castello’s fraud, TCW executives testified that they would have immediately seized control of CBI if they had become aware of that scheme.
Understating CBI’s year-end accounts payable was one of the methods Castello and his confederates used to distort CBI’s 1992 and 1993 financial statements. At any point in time, CBI had large outstanding payables to its suppliers, which included major pharmaceutical manufacturers such as Burroughs-Wellcome, Schering, and FoxMeyer. At the end of fiscal 1992 and fiscal 1993, CBI understated payables due to its large vendors by millions of dollars. Judge Burton Lifland, the federal magistrate who presided over the lawsuit stemming from Castello’s fraudulent scheme, ruled that the intentional understatements of
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CBI’s year-end payables were very material to the company’s 1992 and 1993 financial statements.
E&Y’s 1992 and 1993 CBI Audits
In both 1992 and 1993, E&Y identified the CBI audit as a “close monitoring engagement.” The accounting firm’s audit manual defined a close monitoring engagement as “one in which the company being audited presents significant risk to E&Y … there is a significant chance that E&Y will suffer damage to its reputation, monetarily, or both.” E&Y’s workpapers for the 1992 and 1993 audits also documented several “red flags” suggesting that the engagements posed a higher-than-normal audit risk.