KPMG Has A $1 Billion New Century Problem

By Francine • Apr 2nd, 2009 • Category: KPMG, Latest, New Century, Pure Content, The Case Against The Auditors

From Jennifer Hughes in the Financial Times:

“KPMG is being sued for $1bn by the liquidators of New Century, the collapsed subprime lender, in the first big case against an auditor arising from the current financial crisis.

In a court filing on Wednesday, lawyers for New Century’s liquidators claimed that KPMG “assisted in the misstatements and certified the materially misleading financial statements” filed by the lender. They claim KPMG was responsible for its collapse because it allowed the lender to use inappropriate accounting that led it to underestimate the provisions it needed to cover bad loans. This made its position look better and gave it access to more funds…”

And Donna Kardos in the WSJ:

The lawsuits filed Wednesday said that specialists at KPMG tried to point out errors in New Century’s financial statements but were silenced by the KPMG partner in charge of the audits “to protect KPMG’s business relationship with, and fees from, New Century.”

The claims are among the first to attempt to blame auditors for the subprime-mortgage crisis, which spread beyond lenders such as New Century and engulfed the global financial system.

If the New Century trustee is successful, ”it may embolden others to look more closely at the possibility of bringing [accounting] firms to some level of culpability for the things that happened,” that led to the credit crisis, Francine McKenna, president of McKenna Partners LLC, a corporate-governance consultancy, said in an interview.

KPMG had a tough day all around as yesterday also saw stiff sentences handed down to two former KPMG’ers related to their tax shelter case.

If you’ve been reading this blog, you’re very familiar with the New Century case.  I wrote about New Century for the first time back in March of 2007!

New Century Financial, the US subprime lender scrambling to avoid bankruptcy, hit further troubles on Tuesday as it revealed that it was facing a preliminary investigation by the Securities and Exchange Commission and that it had received a grand jury subpoena from the Department of Justice…The US Attorney is examining trading in New Century’s securities and accounting errors in how much it set aside for loan losses. …The halt, ordered by the New York Stock Exchange, came after New Century said its banks had either cut off credit or signalled their intention to do so, increasing the likelihood of an imminent bankruptcy filing or asset liquidation….

There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements….it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans. Did the ratios drop? Were they delivering their monthly compliance certificates to all the lenders? Were those accurate and truthful? Did the lenders have the right to call the loans unilaterally? It does say that if one called the loans it is likely that all would. Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened?… I find it very curious that no matter how much auditing and disclosing goes on, we continue to see “rapid, unexpected declines” in once high-flying companies that suddenly teeter on the edge of bankruptcy, even though the best and the brightest are supposedly “Keeping Watch” for us as their auditors.

New Century declared bankruptcy in April of 2007. KPMG resigned as New Century auditor in May 2007, shortly afterward. (Unfortunately they were still auditor for Countrywide, the other big ugly mortgage lender, until it was bought by Bank of America.) It was a tough couple of weeks for KPMG, although they were not alone in their pain. All of the Big 4 were experiencing similar pain or the anticipation that they may be tarnished by the same subprime brush.

The litigation-like activities began and the bankruptcy trustee said KPMG was still part of the problem, delaying his investigation. 

And then the bankruptcy examiner’s report pointed the smoking gun at KPMG, almost a year ago to the day.  

The lawsuits filed yesterday are interesting from several perspectives.  I’m going to point to several areas now and expand them in later posts.

1) There’s both a California filing against KPMG LLP, the US firm, and a filing in New York against KPMG International, the umbrella firm for the KPMG “global network” of firms.  Interestingly, and not too surprising to me, the attorney for these cases against KPMG, Steven Thomas, is the same attorney who won the large judgment under appeal in the Banco Espiritu Santo case against BDO Seidman and the one who is going to trial in the same issue against BDO International, their umbrella firm.  

The international cases looks similar and I believe this is a trend.  We’ve already seen Stuart Grant make his case successfully regarding Deloitte’s International firm’s potential culpability in the the Parmalat case.  A similar one will be filed against PwC in the Satyam case, I can assure you. 

2) One potential weak spot in the filings I see is their overemphasis on the “independence” issue.  It seems they are claiming “independence” issues and, therefore, invalid audits and audit related work. This is based on accusations that KPMG rolled over and acquiesced to New Century management even when they knew numbers, assumptions, calculations were wrong.  Not sure the attorneys understand the fine distinction between KPMG neglecting responsibility to their true client, the shareholders and other users of the financial statements, a statutory expectation of due professional care and adherence to standards, versus an actual “independence” conflict.

Did New Century pay KPMG’s bill? How much were the fees?  Were there other prohibited relationships or transactions that compromised the KPMG partners’ and professionals’ true independence and objectivity such as mortgage loans from New Century or personal relationships of the romantic kind?  Had they been planting KPMG professionals in the client over the years?  Those are true independence issues from an accounting and auditing professional standards perspective.  Rolling over and playing dead for the sake of the business is not an “independence” violation, I’m sorry to say.

3) There are a few phrases in the filing that allude to a potential claim theory of “deepening insolvency.”  

From the complaint against KPMG International: “…Had KPMG LLP done its job and upheld its public duty, the problems that caused New Century to fail – or at least to spectacularly increase the enormity of its failure – could have been stopped before they started and materially misstated financial statements would not have been issued in the public marketplace.  Moreover, had its financial statements been fairly presented in accordance with GAAP, New Century could not and would not have incurred billions in liabilities to repurchase mortgages or direct liabilities to lenders.”   

As much as I like the “deepening insolvency” theory on an intellectual level, it’s not been successful.  No less than Judge Posner has smacked it down, for what I believe are very naive and too limiting ideas about the auditor’s role. Maybe those are the limits of the law, unfortunately. Don’t go there.  This one seems clear cut enough on the negligence and professional malpractice points alone.

4) I wrote a few days ago about former PCAOB Chief Auditor and Director of Professional Standards Tom Ray returning to his home firm, KPMG, after several years at the PCAOB.  I lamented the fact that Ray could roll back into his old firm and rejoin as a partner in their Professional Standards group.  I was assured by the PCAOB spokesperson that:

The Sarbanes -Oxley Act of 2002 directed the PCAOB to establish ethics rules for its Board members and staff.  In accordance with these provisions, the PCAOB adopted an Ethics Code that governs the conduct of all Board members and staff.  The PCAOB’s Ethics Code includes "post employment" restrictions (Section EC12(b)) that prohibit Board members and professional staff  from:

 

  • practicing before the Board  (or the SEC with respect to Board related matters) for one year after leaving the PCAOB; and 
  • practicing before the Board  (or the SEC with respect to Board related matters) on particular matters involving specific parties in which the Board or staff member participated personally and substantially while at the PCAOB.  

 

The PCAOB has not yet taken any disciplinary action against KPMG or the KPMG partner for New Century named in the lawsuits.  I guess Mr. Ray is free to help KPMG defend itself against this one.  I’m sure it won’t come up before the PCAOB or SEC for at least a year. How convenient.

5) I’m sure the attorneys took most of the information about specific conversations and evidence that KPMG looked the other way from the bankruptcy examiner Missal’s report.  Did they think to subpoena the 2005 inspection reports on KPMG from the PCAOB?  It’s highly likely that New Century was one of the clients sampled for inspection during this period by PCAOB. Although the clients cited as exceptions in their inspections reports are not named and are kept a closely guarded secret to the detriment of investors and plaintiff’s lawyers, it may be interesting to see if these lawyers could test that theory.  If there are specific instances where KPMG did not uphold the actual auditing standards, per the regulators’ judgment,  it will be all there (including KPMG’s response to any exceptions noted) in those reports. In addition, the non- published Part Two of the reports, which talks about the actual quality and risk management processes at KPMG, would also be interesting for this purpose.

In a related case, I can’t wait to see what the report by the PCAOB of their inspection trip to India last year at this time holds as clues to the PwC/Satyam debacle.  Did you know the PwC Satyam partners are still in jail in India, two months later? No, the PCAOB’s report is still not issued!

6) With BDO International case, the Deloitte International/Parmalat case, an inevitable PwC/Satyam case,and now this suit against KPMG International, the audit industry is extremely vulnerable on the “global network” issue.  

7) Can KPMG claim they were “duped” as they have in their counter suit against Fannie Mae? Will cases against New Century directors and officers go to trial first and guilty pleas/convictions of New Century executives for fraud diminish the case against auditor like they did in Refco?

8) KPMG were also the auditors of Countrywide. ( I think there was a “models” problem there, too.)  They are still auditors of Citigroup.  Who’s next?  Many claiming this is first subprime related case against auditors but NJ recently sued Lehman and their auditor EY.  And Deloitte is being sued over Bear Stearns and over WAMU. 

 

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36 Responses »

  1. I saw that you were quoted on this in the WSJ today. I can remember when I found this blog over a year ago, I never thought it would garner you this much noteriety. You should be proud!

    Also, interesting point on the emphasis on independence issues. I’ve spent more time reading the parts in the filing about the residual interest models and the audit work performed over them so I missed that entirely.

    Have a good day.

  2. @TML
    Thanks. It’s harder than it looks to do any of this. But it’s my passion and that’s starting to show outside of our unique world.
    Francine

  3. [...] For the link to my post on the filing of the two lawsuits by the New Century bankruptcy trustee against KPMG LLP and KPMG International, go here. [...]

  4. Francine, I know Michael Missal of K&L Gates was the examiner, any idea who the forensic accountants were?

  5. Nevermind, I found it- BDO Seidman were the FA’s and forensic accountants- thats a bit of a shocker…

  6. @Forensic Accountant
    Yes, it is a bit of a shock. I did not know that. Going to dig into that further.
    Thanks.
    Francine

  7. Is this as big as Enron? I am really hoping some Big 4 fail and the goverment picks up the regulation. I would love to audit – but with a goverment employee mentality. And of course the nice retirement.

  8. [...] recently so didn’t have time to cover the PwC $1 billion problem re: New Century. Thankfully, Francine McKenna shone her laser light on it. There is one thing with which I disagree: As much as I like the “deepening insolvency” theory [...]

  9. [...] so didn’t have time to cover the KPMG $1 billion problem re: New Century. Thankfully, Francine McKenna shone her laser light on it. There is one thing with which I disagree: As much as I like the “deepening insolvency” theory [...]

  10. Francine, you are exactly what the major newspapers fear most. Someone who can investigate important matters w/out being tied into the established media outlets. Great work! If we are honest, we would expose this for what it is. I hope however that it doesn’t turn out to be something like we saw in the journal today surrounding Ted Stevens. That is pretty bad. It seems to me the PCAOB is useless in terms of the letter of the law, and that is a big problem. Just another example of big government not working properly.

  11. >>KPMG had a tough day all around as yesterday also saw stiff sentences handed down to two former KPMG’ers related to their tax shelter case.<<

    What is very interesting is that all the KPMG folks walked away due to the gov’t hard-charging rights-restricting approach. Let’s hope that those KPMG folks who “beat the rap” have a drink for John Larson (who was not protected since he wasn’t with KPMG at the time of the event) who got 10 years’ time in prison.

  12. Francine, this is HUGE. Have you heard any discussions about Bear Stearn and WAMU following suit? When Bear Stearn imploded, everyone thought there was a clear case against Deloitte. Surprisingly, nothing has happened.

    On another topic, while the DT & KPMG layoffs have been blamed on the economy, it seems that many other factors are at play — specifically, billion dollar law suits. Any updates on the Deloitte Flanagan story?

  13. @Anonymous 9:58

    Bear Stearns hedge funds have already sued Deloitte. http://www.bloomberg.com/apps/news?pid=20601103&sid=aCNSu3EEtPRA&refer=us
    WAMU class action includes Deloitte. http://www.blbglaw.com/cases/00067

    So this is really not the first suit, but mainstream media not really following closely from auditor perspective.

    No news on Flanagan case, even though I thought there was supposed to be a court date in February. Have to ask some folks some questions, like Deloitte’s and his lawyers.

  14. Tom Ray is not head of the prof pratice group at KPMG…Larry Leva is.

  15. @Anonymous 10:46

    Fixed. Should not have implied he was taking charge of the group. Although, maybe Mr. Leva just doesn’t know it yet.
    Francine

  16. @12 — aren’t the law suits part and parcel with the economic downturn? Layoffs are directly related to the economy, nothing more. Law suits that are justified and lead to guilty verdicts lead to firings… but as long as the economy is strong, the innocent staff are absorbed by other partners. Besides, this law suit is a complaint that the auditor did not adequately represent the state of the financials that lead to bankruptcy. If there was no economic downturn would there be a bankruptcy, would there have been anything for the auditors to miss, would the partner have pressure to tell his staff to look the other way (allegation, not a proven act mind you). Do you really think layoffs are due to a law suit that may or may not lead to a large settlement? If there is to be a large settlement, the firm needs to earn the money to pay it out… they need work and staff members to perform that work.

    This is how we line the partner’s pockets (as many on this blog think) with money that they do not deserve… but no one empathizes with the risk they take which takes that wealth away from them. I am not willing to take that risk – are you? You may be a partner of the highest integrity, and some other corrupt partner messes it all up for you. You take on not only your own risk, but that of every other partner in the firm. They aren’t that wealthy – not really.

  17. [...] “alleged” negligence and complicity by auditors, such as in the recent lawsuit against KPMG in the New Century case, there are often others both in the company and in the firm who tried to tell the audit partners [...]

  18. [...] News Sources wrote an interesting post today onHere’s a quick excerptFrom Jennifer Hughes in the Financial Times:“KPMG is being sued for $1bn by the liquidators of New Century, the collapsed subprime lender, in the first big case against an auditor arising from the current financial crisis.In a court filing on Wednesday, lawyers for New Century’s liquidators claimed that KPMG “assisted in the misstatements and certified the materially misleading financial statements” filed by the lender. They claim KPMG was responsible for its collapse because it allowed the lend [...]

  19. [...] KPMG and New Century [...]

  20. [...] is Thomas limbering his fingers and toes for the big prize, US$1 billion dollars or more from KPMG International for New Century?  Is Thomas going to be the one to bring the monster suit against PwC International for Satyam? I [...]

  21. Client lawsuits aside, KPMG’s former employees (not just 2 or 20 but 100s of them) have filed a lawsuit against the firm for the mistreatment dished out by the firm to their employees. Everyday we are receiving partner emails stating that some of the current employees will be questioned. Isn’t that amazing? It goes to show what a slaughterhouse this firm is. If I didn’t have any responsibilities I would rather sit at home than work for them.

  22. @SS – what mistreatment is being dished out? Are they just angry because they were laid off – and do not think they should have been chosen? Are you talking about the overtime pay lawsuit? That is only a handful of employees – but they are attempting to make it class action. It is tenuous at best IMO. If these employees win the overtime pay it will completely chance the situation for new college grads. Odds are their hourly rate will decrease dramatically – and their overall pay with overtime will be similar to their current salaried. In addition, once the staff member wants to transition to exempt status — i.e., get promoted… at that time a lot of staff will get cut as they will likely have to “apply” for the position rather than be promoted into it.

  23. [...] “global brand” arguments. Mr. Thomas is applying his principles in the case against KPMG on behalf of the New Century Trustee.  They’ve filed against the US firm in California and against KPMG International in New [...]

  24. [...] deepening insolvency arguments have been shot down by no less than Judge Posner whose pernicious pragmatism forces him to engage in the self-delusion that helping companies remain [...]

  25. [...] a detailed litigation roadmap in a subprime/crisis era fraud and point to auditor malpractice. The New Century Bankruptcy Examiner’s report made quite a splash, too, when it came out.  It also provided a litigation roadmap and included a [...]

  26. [...] KPMG.  When the New Century Trustee v. KPMG US and KPMG International lawsuit comes to trial, you can bet the media will suddenly remember there’s an auditor [...]

  27. [...] is now being sued for $1 billion for its sins at New Century. Donna Kardos in the [...]

  28. [...] is now being sued for $1 billion for its sins at New Century. Donna Kardos in the [...]

  29. [...] Barrett does a great job of putting the Lehman Report in the context of other bankruptcy examiner reports that have added significant actionable knowledge to high profile fraud cases such as Refco and New Century. [...]

  30. [...] In March 2007 I warned you for the first time about repurchase risk. We were talking about New Century Financial. [...]

  31. [...] of this year: “The deepening insolvency arguments have been shot down by no less than Judge Posner whose pernicious pragmatism forces him to engage in the self-delusion that helping companies remain [...]

  32. [...] for clients with highest confidence and trust…” Was he trying to affect the jury pool for the KPMG/New Century trial? Save some of that for your panel, [...]

  33. [...] email address, contact phone numbers and CVs of all audit partners in charge of accounts where your clients, the shareholders, are suing you. Even better, publish assignments for all clients. That would certainly spice up the [...]

  34. [...] firms are preoccupied with significant legal issues in the US. KPMG has an upcoming trial for the New Century collapse. PwC is still being sued by angry AIG shareholders. Deloitte has plenty to do defending [...]

  35. [...] New Century Financial didn’t reserve adequately for repurchase risk. KPMG, their auditor, settled claims they allowed executives to fudge the models used to make the estimates. A “sudden” liquidity crisis ensued when all their warehouse lines were called at once. [...]

  36. [...] mortgage securitizations and repurchase risk being told, “We’re done here” when he warned at New Century Financial that the client’s models had obsolete assumptions. That ugly episode only came to light because [...]

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