A study of the new century financial corporation

New Century Financial Corporation was originally founded in 1995. It was a Maryland corporation based in Irvine, California in business to originate, purchase, sell and service home mortgage loans. Court documents reported the company experienced phenomenal growth during its 10 year history, originating $350 million in mortgage loans in 1996 to $50 billion in 2005 with earnings per share increasing $.013 to $7.17.

New Century was an aggressive subprime lender catering to customers who could not qualify for conventional mortgage loans. New Century would then pool these loans and sell them in the mortgage secondary market at a profit. These loan sales came with warranties and representations which if breached could require New Century to repurchase the loans at a substantial loss. These repurchases began increasing in 2004 and were soon taking a toll on the company’s liquidity. Still, as late as the latter part of 2006, the company was able to raise $142.5 million from a new stock issue.

It all came tumbling down February 7th, 2007 when New Century admitted it was restating the company’s financial results for the first three quarters of 2006. The market reaction was a drop of 40% in the stock price from $30.16 to $19.24 according to court documents. By March 13th the stock price had declined all the way down to $.84 after a March 1st announcement informing the public that it’s 2006 10-K filing would be late along with a March 12th announcement disclosing a discontinuance of financing by some lenders. This crippled the company’s ability to honor loan repurchase demands. New Century Financial filed for bankruptcy protection on April 2nd 2007.

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KPMG LLP and KPMG International

KPMG LLP was New Century’s independent auditor from 1995 thru 2006. KPMG is “a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative, a Swiss entity with over 137,000 employees operating in 144 countries” according to their website.

New Century Financial – What Fraud Happened?

The executives at New Century Financial violated many accounting rules and U.S. laws. The three perpetrators in this case are the former CEO Brad Morrice, former CFO Patti Dodge, and former Controller David N. Kenneally. The offenses are related to New Century’s disclosure fraud, violations of the Sarbanes- Oxley Act, violations of generally accepted accounting principles, and violations of the Securities Act.

DISCLOSURE FRAUD

New Century Financial failed to make adequate disclosures regarding its loan production (the nature and risk of its products), its loan repurchase obligations, and its backlog of repurchase requests. In the 2006 Forms 10-Q, both Morrice and Dodge, failed to disclose that a substantial portion of it new loans were derived from what are termed 80/20 loans, where New Century would underwrite 80% of the first loan on the property, and underwrite a second loan for the additional 20%, actually creating a 100% loan to value ratio. These loans were risky, because the buyer of the property was able to make the purchase without risking any money of their own. In 2006 33.47% of New Century Financial’s loans were of this type, up from 23% in 2004 and 9% in 2003.

Additionally, New Century disclosed materially misleading loan to value (LTV) information on its loans. To the public, “New Century disclosed a ‘weighted average’ LTV, which in 2006, was between 80.9% and 81.4%,” of total loans made, but in company internal reports the actual numbers were between 86.6% and 87.6%. Also in the 2006 Forms 10-Q, “New Century made disclosures that downplayed the risks of its interest only and stated income loans, (loans in which one’s income is not verified).” New Century failed to disclose that through the second quarter of 2006 that it was actually experiencing greater defaults on its 80/20, stated income and layered risk loans.

Regarding New Century’s loan repurchase obligations, adequate disclosure was not given to investors. Under the contract for the loans, “New Century could be required to repurchase loans sold pursuant to repurchase agreements in two situations: (1) the representations and warranties about the loan were untrue; or (2) the borrower defaulted on the loan by failing to make the first payment due after the loan was sold.” These loan repurchase obligations would have negatively affected investor and lender expectations of New Century’s earnings potential had they been disclosed. In 2006 New Century experienced an increasing rate of Early Payment Defaults and First Payment Defaults, which could trigger the loan repurchase obligation. In 2006 New Century had to repurchase $784.3 million dollars on loans, and was left with loans with a value of 80% of the repurchase price.

In addition to its actual repurchases, New Century had a backlog of repurchase requests that it did not disclose in 2006. From 2005 to 2006 the backlog grew from $143 million to $400 million. Failure to disclose these significant facts greatly altered the information available to investors regarding the Company and would have had an unfavorable impact on net revenues and income from continuing operations.

SARBANES-OXLEY VIOLATIONS

In violation of the Sarbanes-Oxley Act, the CEO, CFO, and company Controller personally signed New Century’s disclosures, first and third quarter 10-Q forms, and the Sarbanes-Oxley certifications associated with those filings knowing that the financial statements were materially misstated. Furthermore, each of the company officers benefited from the financial misstatements in terms of pay, and bonuses, none of which was returned to shareholders. During the year 2006 the CEO and CFO made misleading statements in press releases and earnings calls regarding the financial position of the company.

ACCOUNTING FRAUD

In line with generally accepted accounting principles, New Century Financial was required to estimate the fair value of its repurchase obligation and to reduce the gain it reported on the sale of that amount. In deriving an estimate of this obligation New Century was required to estimate, “(1) the amount of loans that it would have to repurchase, i.e., the repurchase rate: and (2) the costs that it would incur in repurchasing loans. When New Century repurchased a loan it was recorded at the loan’s unpaid balance and not at the fair value as required under SFAS 140. However, prior to the second quarter of 2006, the repurchase reserves recorded by New Century Financial were sufficient to state the net value of the assets in amounts materially in compliance with SFAS 140. In the second quarter of 2006, however, the reserve calculation methodology was changed resulting in much lower reserves. As a result of these changes, the net assets were no longer stated at fair value, a violation of SFAS 140. This reduced its repurchase expense and overstated revenues.

Also under GAAP, New Century was required to estimate contingent liabilities, in line with SFAS 5. SFAS 5 requires accrual of loss contingency if information indicates that it is probable that the liability has been incurred and the amount can be reasonably estimated. The liability related to the substantial backlog of unprocessed repurchase claims was not properly accrued, a violation of SFAS 5. This allowed New Century to overstate its financial performance.

New Century also failed to implement internal controls over financial reporting to appropriately track repurchase requests from investors to buy back their loans, further reducing the firm’s loss contingency.

As a result of improperly accounting for loan repurchase obligations, which reduced the reserve expense needed to repurchase those loans; New Century overstated its financial results, with reported pre-tax earnings 165% higher than the corrected amount (a total overstatement of approximately $84 million). In the third quarter of 2006, earnings were overstated approximately $108 million.

VIOLATIONS OF THE SECURITY ACT

In connection with the November 16, 2006 securities offering both Morrice and Dodge filed with the Securities and Exchange Commission, they reported that New Century’s financial statements presented fairly in all material respects the financial condition of the company. Furthermore, it was stated that New Century Financial had no undisclosed material liabilities, and that the financial statements complied with the requirements of the Exchange Act. The reality was that, “New Century had a substantial backlog of pending repurchase claims, which were not reflected as liabilities in New Century’s financial statements.”

With all of these defalcations combined the executives at New Century Financial violated the following laws:

Fraud in the Offer or Sale of Securities, Section 17(a) of the Securities Act

Fraud in Connections with the Purchase or Sale of Securities, Section 10(b) of the Exchange Act and Rule 10b-5

Violations of Commission Periodic Reporting Requirements, Aiding and Abetting Section 13(a) of the Exchange Act and Rules 12b-20, 13a-11, and 13a-13

Circumvention of Internal Controls, Section 13(b)(5) of the Exchange Act

False Statement to Accountants, Rule 13b2-2

Certification Violations, Rule 13a-17 of the Exchange Act

Failure to Reimburse, Section 304 of the Sarbanes-Oxley Act

KPMG’s Role in the Fraud

KPMG LLP (“KPMG”) was the external auditor for New Century Financial from inception (1995) to 2006. They resigned in April 2007, a few months after New Century filed for bankruptcy. Although they had completed a significant portion of the field work for the 2006 audit prior to their resignation, they did not issue an opinion on the 2006 financial statements. They issued unqualified opinions in all prior years audited by them. They also performed reviews of the quarterly financial statements through 2006 and performed audits of the effectiveness of internal controls at New Century (SOX 404 audits) for 2004 and 2005. The SOX 404 audit for 2006 was substantially completed but the opinion was not issued as of KPMG’s resignation.

Although financial statements are the responsibility of management, an independent auditor’s opinion that the statements “present fairly, in all material respects, the financial condition of the Company” “in accordance with generally accepted accounting principles” does provide investors and creditors a certain level of assurance that management’s statements are reliable. The opinion is not a “guarantee” of the accuracy of the financials but the public should be able to trust that, at a minimum, the auditor followed professional standards in the audit process. An auditor’s role in the issuance of fraudulent financial statements, then, could come from either a) their failure to exercise due care in the audit process which resulted in their failure to discover and communicate material misstatements or b) their complicity in the fraudulent misstatements.

Most of what we know about KPMG’s relationship with New Century and their work as New Century’s auditors comes from a report by Michael Missal, the bankruptcy examiner in the New Century case, to the United States Bankruptcy Court. Mr. Missal was charged with identifying any potential causes of action that might arise from the New Century bankruptcy. He reviewed KPMG’s audit workpapers and New Century’s accounting records and interviewed KPMG and New Century employees as part of his research.

Missal’s report focuses primarily on KPMG’s work during 2005 and 2006. He suggests that, during those years, KPMG failed to follow professional audit standards and that certain members of the audit team were complicit in the fraud by giving advice to New Century, which was followed by them, that was inconsistent with generally accepted accounting principles and that resulted in material misstatements.

The evidence presented to support the contention that KPMG failed to act in accordance with accepted auditing standards (GAAS)) was substantial. The three general auditing standards require that 1) the auditor must be technically competent, 2) the auditor must be independent and 3) the auditor must exercise due professional care. Mr.. Missal provided evidence that KPMG failed to meet any of those standards.

Mr. Missal reviewed the New Century engagement staffing during 2005 and 2006. During the first quarter review in 2005, the entire audit team was new to the engagement (other than two junior auditors). The engagement partner was new to KPMG and had very limited experience in the mortgage banking industry. The senior manager was a recent rehire of KPMG and his only industry experience was a three year stint as an assistant controller at a small mortgage lending company. The senior manager on the 2005 SOX 404 audit had no prior SOX 404 audit experience. The concurring partner had worked primarily with financial institutions and leasing companies. Field work on two of the most sensitive areas (testing of the repurchase reserve and residual interest valuation) was done by first year auditors. Given the complexity of the mortgage banking industry, Mr. Missal argued that the team did not have the technical skill required to audit New Century.

Mr. Missal reviewed internal communications between KPMG staff and external communications between KPMG and New Century management and board members. The senior members of the audit team ignored or dismissed concerns raised by KPMG specialists about the appropriateness of certain accounting methods used by New Century. They also dismissed concerns raised by junior auditors and by members of New Century’s Audit Committee as unfounded. Mr. Missal concludes that the senior audit members were more concerned about retaining the client than they were about the quality of the audit work and therefore lacked independence.

There were numerous examples given by Mr. Missal to demonstrate KPMG’s lack of “due professional care” including their failure to follow the second and third field work standards (the auditor must design tests to adequately respond to their understanding of the entity’s internal controls (or the lack of internal controls) and is required to obtain sufficient evidential matter to support their opinion). The examples given included KPMG’s failure to expand testing based on deficiencies noted in their review of New Century’s controls as part of the audit planning process, failure to properly test the repurchase log, failure to properly test the models developed by New Century accounting personnel to determine the reserve requirements, failure to expand testing given significant changes noted in the number of loans repurchased and failure to expand planned testing when the risk assessment related to residual interests was changed to high (as part of the SOX 404 audit work in 2006). Mr. Missal also noted that certain significant control deficiencies noted as part of the 2004 SOX 404 audit were not communicated, as required, to the Board of Directors and that the 2005 SOX 404 audit did not consider, as required, the failure of New Century to resolve control deficiencies noted as part of the prior year SOX 404 audit.

Mr. Missal also provided evidence KPMG was complicit in the fraud. According to interviews of KPMG and New Century staff, the Senior Audit Manager on the engagement team suggested two changes to the calculation of the repurchase reserve which were adopted by New Century during 2006. Both changes resulted in significant reductions of the amount of the reserve recorded in the financials and both changes were contrary to GAAP. Mr. Missal does not suggest that the actions were criminal. The inference is more that the suggestions were made based on a lack of understanding of the applicable GAAP as it applied to the mortgage industry.

To date, KPMG has not responded to specific issues raised in Mr. Missal’s report. They have, however, issued a general statement that they believe the firm complied with all professional standards. It should also be noted that the SEC, in their action against New Century, included a claim that New Century had lied to their auditors.

Mr. Missal does conclude that although he believes that the trustees for New Century could have a reasonable basis for suing KPMG for professional negligence, he also cites a number of possible defenses that could be raised by KPMG. All of the defenses speak directly, or indirectly, to New Century’s contributory negligence.

The Affect of the Fraud on KPMG

No charges have been brought against KPMG by the SEC. However, both KPMG and their parent firm, KPMG International (KPMGI) were sued in April of 2009 by The New Century Liquidating Trust and Reorganized New Century Warehouse Corporation (the trustee overseeing the bankruptcy).

The suit against KPMGI has two causes of action. The first cause of action states that KPMG is an agent of KPMGI and therefore KPMGI is liable for the actions of KPMG (“vicarious liability”). The second cause of action claims “deceptive and unfair business practices” by KPMGI. KPMGI advertised that its member firms performed quality work but did not properly oversee or control that quality. The suit seeks, in part, actual compensatory and consequential damages and punitive damages plus costs.

The suit against KPMG has three causes of action. In the first cause, the plaintiff requests that the agreement signed by KPMG and New Century prohibiting New Century from seeking punitive damages be set aside as illegal under California law. In the second cause of action, the suit claims that KPMG was negligent in their performance as New Century’s auditors. The lawsuit includes the claims reported in Mr. Missal’s report as described in the section “KPMG’s Role in the Fraud” above. In the third cause of action, the suit claims that KPMG aided and abetted the breach of fiduciary duties by New Century’s directors and officers. The suit claims that KPMG was aware of the breaches of duty and that the engagement team provided “assistance and encouragement” in those breaches. The suit seeks, in part, actual compensatory and consequential damages (in an amount not less than $1 billion) and punitive damages plus costs. Since the suits have not been settled, there is no way to know or estimate the financial impact on KPMG.

KPMG has undoubtedly been affected in unpublicized ways. Mr. Missal notes several of the engagement team members left KPMG or were transferred out of the local office during 2007. There have probably been changes in internal processes related to engagement management and technical review. It is possible KPMG has lost clients as a result of the publicity surrounding the case.

Since the final outcome of these cases is still unknown, it’s impossible to evaluate the complete effect upon KPMG LP and KPMGI.

KPMG’s Violations of Legal and Ethical Standards

New Century’s auditor, KPMG LLP (and its parent company KPMGI) is a large multinational auditor which employees over 135,000 people in over 140 countries. The breadth of accounting law and ethical standards it may be bound to is diverse and multilayered, including regional, state, national, and international provisions. To illustrate this fact both New Century and the US arm of KPMG were incorporated in Delaware, while headquartered in Irvine, California and New York City respectively, and may be subject to legal precedent in potentially any state in which material business is conducted.

United States accounting standards (GAAP) are primarily set by the Financial Accounting Standards Board. Compliance with GAAP is often required by regulatory agencies such as the SEC and by statutory law both at the state and federal level. Additionally there are an extensive number of statutory requirements which bind both public auditors like KPMG and publically traded entities like New Century on a federal level including SEC provisions and rulings of the Public Company Accounting Oversight Board (PCAOB).

Some examples of potentially breached laws and ethical standards include Article 9, Section 58 of the California Board of Accountancy Regulations which requires CPAs to comply with GAAP and GAAS (Generally Accepted Auditing Standards) since KPMG’s treatment of the reserve requirement was inconsistent under FAS 140 and FAS 5. It is also possible that Section 65 was breached since there were allegations that KPMG sought to maintain New Century as a profitable client over accurate financial reporting thus compromising independence.

At the national level, several AICPA principles and rules may have been compromised. Principles allegedly breached include the principle of objectivity and independence based on the aforementioned profitability rationale, and the principle of due care based on the inconsistent application of GAAP (and alleged technical/professional insufficiency of the audit team). Since the AICPA rules are a codification of the principles, several rules by nature would have been violated including the following, rules 101, and 102, plus rules 201 through 203.

Rules 101 and 102 which govern independence and integrity/objectivity respectively were potentially breached by the conflict of interest associated with retaining profitability clients which would have affected both independence and objectivity. Rule 201, the General Standards is broken down into 4 parts each of which may have been broken during the anomalous treatment of the reserve requirement among other accounting guidance provided by KPMG. Rule 201 A which dictates professional competence and rule 201 C which dictates appropriate levels of planning and supervision may have been violated if the audit team was insufficient in technical skill and frequently unsupervised as alleged. Rule 201 B which prescribes due care again may have been breached by inconsistency in the application of GAAP.

Lastly there is evidence that the last and final provision of rule 201 was breached, section D discusses the acquisition of sufficient supportive evidence of audit opinions and there is evidence that the audit team may have cut the engagement short on account of time and profitability pressures.

What could have been done to prevent the fraud?

Severing the financial incentive between client and auditor by mandating that auditing fees be paid via a trustee or other third party irrespective of audit findings could significantly reduce the pressure to deviate from GAAP and decrease conflicts of interest. Perhaps a pooled system like insurance could be created where publicly traded firms, those regulated by the SEC and the PCAOB, would pay into a pool of funds from which fair compensation can be disbursed, reducing profit based incentives from altering the quality of audit findings. Rotating audit firms by lottery or by imposing some form of “term limits” may prevent the collusion often formed by longstanding relationships.

The creation of an anonymous complaint system by regulatory authorities could provide an outlet for junior members in auditing firms to report major violations of standards by higher levels of management in both the company being audited and the accounting firm itself. Additional individual penalties for failure to exercise due care, especially for senior members, may insure work is not rushed or delegated improperly while preserving the limited amount of competition remaining in the public auditing industry.

But at the end of the day it is always about the basics. A framework is in place to prevent financial fraud by companies. The framework is:

Generally Accepted Accounting Principles

Generally Accepted Auditing Standards

Corporate governance exercised by the Board of Directors

The failure of New Century Financial was not so much a regulation failure but a human failure. But this is why we have regulations-to reduce the temptations of humans. Strict adherence by KPMG to the generally accepted auditing standards would not have prevented the failure of New Century, it probably would have speeded-up its demise. But it would have given New Century’s investors, creditors, and board the critical information needed to make sound decisions.

The potential for human failure in both New Century and KPMG could have been reduced by what is now termed “the tone at the top”. New Century’s board, especially the audit committee and the upper management of KPMG did not provide the environment for the violations to come to their attention. KPMG’s ignoring of the warnings of junior staff and specialists of problems is inexcusable.

How did the New Century failure affect our group’s views and opinions?

A former auditor in our group “understood the tension between the auditor’s duty to follow professional standards and their desire to retain clients. Comparable tensions exist for accountants in private industry. I also know that hindsight is 20/20 and without hearing the defendants’ side of the story, it’s difficult to fairly evaluate their work or their ethics. It’s difficult to read about the economic and personal impact that these large corporate failures have on the various stakeholders – the employees, the investors, the creditors, and the public – without wanting to see changes that will at least reduce the risks we all face. Maybe it’s time to make the auditors more independent – which might mean that auditors should be paid by someone other than the audit client and that audit firms serving public companies need to be rotated on a regular basis.”

A CPA candidate in our group felt “reminded of the constant conflict between quality and quantity; profitability and sustainability. The pressures placed on auditing firms by virtue of the free market often creates particularly troublesome adverse incentives which I may be subject to one day, this is unfortunate. These same pressures are the reasons why public accounting is needed in the first place, typified by New Century’s unsustainable financial position over time, and reminded me of just how important it is to maintain trust and faith in the public accounting industry.”

Another CPA candidate felt “disillusioned of the culture of the ‘Big Four’ accounting firms.” Noting the firms are quick to lecture others about “tone at the top” but are they looking at the “tone at the top” in their own organizations? He added “do I want to work at a place where the input of juniors is routinely dismissed? Where was the quality control mechanism at KPMG?”

Finally, one of us believed “this case only confirmed my views about the people involved in the Real Estate/Mortgage market, most of them were in the market to make a quick buck, 99% of the people in this industry had no understanding of the real estate market or did not care, and the market was doomed to collapse due to weak lending practices.”