New Century Bankruptcy Examiner Says KPMG Aided Fraud
March 26 2008 - New Century Financial Corp.’s bankrupt estate might have cause to sue its former accountant KPMG LLP and some directors and officers for improper accounting leading up to its bankruptcy, a court examiner said in a report.
The company, once the second-biggest U.S. subprime-mortgage lender, engaged in accounting fraud in 2005 and 2006 before filing for bankruptcy in April 2007, according to the 581-page report by court examiner Michael J. Missal unsealed today.
New Century “engaged in a number of significant improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes,” Missal wrote in the report. He said “KPMG contributed to certain of these accounting and financial reporting deficiencies by enabling them to persist” and in some cases “precipitating” a departure from “applicable accounting standards.”
“This is really the embryo of the credit crisis,” Missal said today in a phone interview. “The theme of the report is how easily the loans were originated, how exceptions were made, how they used bad appraisals. There were no appropriate internal controls, and KPMG failed to look at these things skeptically.”
Missal said the bankrupt estate may be able to sue KPMG for professional negligence. KPMG resigned as independent auditor of Irvine, California-based New Century on April 27.
“We strongly disagree with the report’s conclusions concerning KPMG,” firm spokesman Dan Ginsburg said in a phone interview. “We believe that an objective review of the facts and circumstances will affirm our position.”
SEC Investigation
The U.S. Securities and Exchange Commission is also reviewing KPMG’s role as New Century’s auditor and has subpoenaed the accounting firm, two people familiar with the matter said. They declined to be identified because the inquiry isn’t public.
Ginsburg declined to comment on whether the SEC has subpoenaed KPMG.
Missal said the estate may also have reason to sue directors and officers to seek recovery of bonuses paid to them in 2005 and 2006 because those bonuses were tied to incorrect financial statements.
The estate “could seek millions of dollars in recoveries,” according to the report. Missal said in an interview that some bonuses for executives were in the “tens of millions” of dollars.
Three founders of the company, former Chairman Robert Cole, former Vice Chairman of Finance Edward Gotschall and former Chief Executive Officer Brad Morrice received bonuses in 2005 “that were at least 300 percent more than they should have been,” according to the report. The bonuses were based on profits resulting from bad accounting, Missal said in the report.
Loss, Not Profit
Because of the accounting failures, New Century reported a profit of $63.5 million in the third quarter of 2006 when it should have reported a loss. The company reported that earnings grew 8 percent for that quarter, when they actually declined at least 40 percent, according to the report.
“While we have not yet had a chance to review the report, Mr. Gotschall and Mr. Cole have cooperated and will continue to cooperate with the examiner and any other inquiries,” Charles Sipkins, a spokesman for the two, said in a phone interview. Sipkins declined to comment further.
New Century spokesman Dan Gagnier said in an e-mail that the company is “pleased that the Examiner’s report is finally completed and that we can take the next steps of confirming the plan of liquidation.” Gagnier declined to comment further.
KPMG’s Recommendation
According to the report, New Century engaged in seven kinds of improper accounting, including understating its repurchase reserve — money set aside to repurchase bad loans. In the third quarter of 2006, New Century understated this reserve by at least $104.8 million, at a time when “the company was being flooded with repurchase claims from investors,” Missal said.
The examiner said several people he interviewed for the report claimed KPMG recommended the improper changes to the reserve calculation, and KPMG denied doing so. Work papers show KPMG “evaluated and approved the change,” Missal said.
From 2004 to 2006, “investors rejected around $800 million in loans simply due to missing documentation, and billions of dollars of loans for other reasons,” Missal said.
Missal described how increasingly risky loan-origination practices created the problems which led the company to cover up its situation through faulty accounting.
Underwriting Exceptions
New Century’s loan originations, which rose from $14 billion in 2002 to $60 billion in 2006, increased as the company made exceptions to its underwriting guidelines and gave money to homeowners who couldn’t afford rates past the low initial “teaser rates,” eventually creating “a ticking time bomb that detonated in 2007,” Missal said.
Former New Century employees asked a judge on March 19 to unseal the report, saying that without it, they didn’t have enough information to know whether they should vote in favor of New Century’s liquidation plan.
Investigators had announced they were looking into New Century’s accounting in March 2007, prior to bankruptcy and the SEC said in July 2007 that is was stepping up a probe into the company’s practices.
The case is In re New Century TRS Holdings Inc., 07-10416, U.S. Bankruptcy Court, District of Delaware (Wilmington).
New Century Bankruptcy Examiner Says KPMG Aided Fraud
By Tiffany Kary | Bloomberg