KPMG Has A $1 Billion Problem At New Century

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.

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

Back then, I wrote:

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.