Complaint Jacobs V. KPMG (00002662)
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UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
THE NEW CENTURY LIQUIDATING TRUST AND REORGANIZED NEW CENTURY WAREHOUSE CORPORATION, by and through Alan M. CIV. NO.: Jacobs, Liquidating Trustee and Plan Administrator, COMPLAINT AND Plaintiff, JURY DEMAND v. KPMG International, Defendant.
The New Century Liquidating Trust and Reorganized New Century
Warehouse Corporation, by and through Alan M. Jacobs, as Liquidating Trustee and Plan Administrator (the “Trustee” or “Plaintiff”) (together “New Century”), hereby sues KPMG International (“KPMGI”) and states, on knowledge as to himself and his actions, and information and belief as to all other matters, as follows:
INTRODUCTION
I. KPMG Owes a Public Duty 1. Audits of financial statements can only be done by independent, certified public accountants. Audits of public companies like New
Century are required by law to protect creditors, the investing public, the
Company’s employees and other stakeholders, and the Company itself. Because of this special responsibility the United States Supreme Court holds auditors like
KPMG to be the “public watchdog.”
2. As New Century’s auditor, KPMG failed its public watchdog duty. The result was catastrophic.
3. Founded in 1995, New Century was a mortgage finance company that both originated and purchased residential mortgage loans, the majority of which were subprime loans. As the subprime mortgage market grew, so did New Century — New Century’s reported assets grew from $300,000 in
1996 to $26 billion in 2005.
4. With the backdrop of New Century’s rapid growth, New
Century’s Board of Directors and Audit Committee questioned management’s incentives to manage earnings and therefore engage in aggressive accounting — precisely the type of risks an independent auditor is there to watch for and respond to. New Century and the users of its financial statements depended on its gatekeeper, KPMG, to ensure that those financial statements were fairly presented in accordance with GAAP and free of material misstatement due to error or fraud.
5. KPMG did not act like a watchdog. Instead, KPMG assisted in the misstatements and certified the materially misstated financial statements.
2 When New Century finally announced its financial statements were false, its stock price dropped 90 percent, New Century could no longer borrow money to finance its lending business and New Century went bankrupt owing billions.
6. As KPMG knew at the time, its audits of New Century had significant ramifications not just for New Century, but for the public. New
Century was at the center of the housing market boom, and when it went bankrupt, not only did thousands of people lose their jobs, but as the New York Times declared: “New Century’s collapse ushered in a series of failures among mortgage lenders — ultimately rocking global financial markets, forcing banks around the world to write down or take losses on nearly $250 billion in mortgage-linked securities and sending the nation’s housing market into a tailspin.”
7. The job of purportedly independent, certified public accountants performing audits matters. The failure of KPMG to do its job at New
Century demonstrates why. This complaint holds KPMG responsible for its failure.
II. KPMG International’s Agent Is KPMG LLP
8. The brand “KPMG” refers to one of the world’s largest accounting firms. Its annual revenue is in excess of $22 billion. It is comprised of
“member firms” around the world that, according to KPMGI, “act according to common values” and provide clients with a “globally consistent” set of services.
9. KPMGI established these “globally consistent services” and
“common values” through rigorous management and control of the “KPMG”
3 brand and the KPMG member firms around the world, including its agent in the
United States, KPMG LLP.
A. KPMG International Promised to Control KPMG LLP’s Quality
10. KPMGI specifically represented that it would ensure that member firms’ work, including their audits, would meet professional standards and regulatory requirements: “[KPMGI] has established policies and procedures to which member firms must adhere to help ensure that the work performed by member firm personnel meets the professional standards, regulatory requirements and the member firm’s quality requirements applicable to their respective Audit,
Tax or Advisory services engagements.” Via these policies and procedures,
KPMGI promised the public it would “maintain the quality and integrity of the accounting profession [that] is vital to the confidence in our global capital markets.”
11. KPMGI’s expansive rights of control ensure “globally consistent services” and include the most fundamental right — the right to take away the “KPMG” brand and put member firms out of business. According to
KPMGI’s annual report, membership with KPMG can be terminated if a firm acts
“contrary to the objectives of the KPMGI cooperative” or KPMGI’s policies and regulations. KPMGI thus can fire KPMG LLP at any time.
12. KPMGI also promised the public “globally consistent training for all auditors within KPMG member firms” and enforced its quality
4 requirements through “an established set of supervisory, review and consultation standards supported by leading technology.”
B. KPMG International Promised KPMG LLP Would Be Independent
13. As to “common values,” KPMGI repeatedly emphasized to the public its requirement that member firms maintain the brand through strict adherence to a “Global Code of Conduct.” KPMGI promised to ensure that its member firms were “independent,” the critical aspect of any KPMG member firm conducting an audit:
Independence, integrity, ethics and objectivity — these are all vital
to the way we work. It is the responsibility of each person working
within a member firm to maintain their integrity and objectivity, to
exercise a high standard of professional judgment, and to comply
with professional judgment, and to comply with professional ethics
and independence policies and requirements.
14. Purportedly to ensure compliance with its ethical prerequisites, KPMGI established and advertised a “comprehensive set of global safeguards in place to help us meet our commitment to independence. These include pre-approval checks for every new client or assignment, systems of avoiding conflicts of interest, and the rotation of audit partners when necessary.”
KPMGI thus not only sought to exact adherence to its own ethical standards – it
5 used its member firms’ alleged integrity and professionalism as a selling point to induce the reliance by clients and investors.
III. KPMG International Breaks Its Promises and Harms New Century
15. KPMGI broke its promises.
16. Despite the absolute authority to manage and control KPMG
LLP and even terminate it as a “KPMG” firm, KPMGI did not ensure the stringent quality control it promised the public. KPMGI touted the KPMG brand as adding credibility to a company’s financial statements because of the KPMG brand’s high standards, yet did not ensure that audits under the KPMG name followed those standards.
17. KPMGI’s broken promise had consequences for New
Century. KPMG LLP was the auditor for New Century, a mortgage finance company that both originated and purchased residential mortgage loans, the majority of which were subprime loans. Despite KPMGI’s promise that it would ensure that KPMG LLP audit services would comply with professional standards and regulatory requirements, KPMG LLP conducted grossly negligent audits and reviews of New Century that violated both professional standards and regulatory requirements.
18. As a result, in 2007 New Century announced that its previously issued financial statements would have to be restated because they did not comply with Generally Accepted Accounting Principles (“GAAP”). KPMGI’s
6 failure to keep its promise and exercise its right and obligation to strictly control the quality of KPMG LLP’s audits cost New Century its existence.
19. Moreover, KPMG LLP failed KPMGI’s most important — and heavily advertised — objective: independence and integrity. Rather than exercise professional, independent and ethical judgment, as KPMGI promised it would, KPMG LLP acted as a cheerleader for management to keep its client happy.
20. When dissenters within KPMG LLP tried to point out the misstatements in the financial statements, they were silenced by the KPMG LLP partner-in-charge of the New Century audits to protect KPMG LLP’s business relationship with New Century and KPMG LLP’s fees from New Century: When a KPMG specialist, John Klinge, continued to raise questions about an incorrect accounting practice on the eve of the Company’s 2005 Form 10-K filing, John
Donovan, the lead KPMG audit partner told him: “I am very disappointed we are still discussing this. As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off.”
21. KPMG then did the unthinkable for a public auditor — it issued its audit report before its audit was complete, falsely enabling New Century to file its Form 10-K.
22. Because KPMG LLP lacked independence, it could not even issue its audit opinions and reviews, and thus its audits failed as a matter of law
7 and ethics. KPMGI, as the principal, is responsible for the severely reckless and grossly negligent acts of its agent.
23. KPMGI itself broadcasts to the public that it would hold its member firms and their partners accountable for complying with its ethical and professional requirements: “In building a global culture of quality, we require our people to be in full compliance with our global policies. To this end, we hold them accountable for their behavior.”
24. This complaint holds KPMGI accountable.
25. KPMGI’s and KPMG LLP’s failure of their public duties through grossly negligent audits in this case prove the truth of the Supreme
Court’s law: KPMG’s certification of false financial statements caused New
Century to lose at least millions of dollars, and working people to lose their jobs.
When certified public accountants fail to do their job as auditors, it matters.
PARTIES
26. Plaintiff is The New Century Liquidating Trust and
Reorganized New Century Warehouse Corporation, by and through Alan M.
Jacobs, as Liquidating Trustee and Plan Administrator. New Century Financial
8 Corporation (“New Century”)1 was a Maryland corporation with a principal place of business in Irvine, California.
27. Less than two months after New Century’s February 7, 2007 announcement that it would have to restate its financial statements due to violations of GAAP, on April 2, 2007 New Century and its operating subsidiaries filed for Chapter 11 bankruptcy.
28. KPMGI is a Swiss cooperative with its principal place of business in the Netherlands. Prior to 2003, KPMGI operated as a Swiss Verein.
29. KPMGI is one of the largest multinational accounting and consultancy firms in the world. According to its website, “we have 137,000 people operating in 144 countries worldwide,” including KPMG LLP in the
United States. KPMGI reports its revenues on a worldwide basis on its web site, www.kpmg.com.
1 The Liquidating Trustee stands in the shoes of the New Century debtors which are the following entities: New Century TRS Holdings, Inc. (f/k/a New Century Financial Corporation), a Delaware corporation; New Century Mortgage Corporation (f/k/a JBE Mortgage) (d/b/a NCMC Mortgage Corporate, New Century Corporation, New Century Mortgage Ventures, LLC), a California corporation; NC Capital Corporation, a California corporation; Homel23 Corporation (f/k/a The Anyloan Corporation, 1800anyloan.com, Anyloan.com), a California corporation; New Century Credit Corporation (f/k/a Worth Funding Incorporated), a California corporation; NC Asset Holding, L.P. (f/k/a NC Residual II Corporation), a Delaware limited partnership; NC Residual III Corporation, a Delaware corporation; NC Residual IV Corporation, a Delaware corporation; New Century R.E.O. Corp., a California corporation; New Century R.E.O. II Corp., a California corporation; New Century R.E.O. III Corp., a California corporation; New Century Mortgage Ventures, LLC (d/b/a Summit Resort Lending, Total Mortgage Resource, Select Mortgage Group, Monticello Mortgage Services, Ad Astra Mortgage, Midwest Home Mortgage, TRATS Financial Services, Elite Financial Services, Buyers Advantage Mortgage), a Delaware limited liability company; NC Deltex, LLC, a Delaware limited liability company; NCoral, L.P., a Delaware limited partnership; and New Century Warehouse Corporation (“NCW”), a California Corporation.
9 JURISDICTION AND VENUE
30. This Court has subject matter jurisdiction over this action pursuant to 28 U.S.C. § 1332 and the amount in controversy exceeds $75,000.
31. Venue is proper under 28 U.S.C. § 1391(d).
32. This Court has personal jurisdiction over Defendant KPMGI.
KPMGI’s contacts with the United States and New York are regular, profitable and purposeful. KPMGI contracts with its agent KPMG LLP, with its principal offices in New York and offices throughout the United States. This contract provides the basis for KPMGI’s pervasive rights to control KPMG LLP, a certified public accounting firm that owed a duty to the public, the citizens of the United
States.
33. KPMGI released annual reports into New York and the
United States promising supervision and quality control over KPMG LLP’s activities here. KPMGI further represented that because of KPMGI’s quality control, KPMG LLP’s use of the KPMG name – exclusively licensed to it by
KPMGI – would lend credibility to New Century’s financial statements.
34. KPMGI also issued a “Global Code of Conduct” in which it sought to demonstrate its commitment to “applying appropriate KPMG methodologies and procedures.” According to KPMGI’s Chairman, the Code of
Conduct “applies to all KPMG partners and employees – regardless of title or position – and serves as a road map to help guide actions and behaviors while working at KPMG.” Through the “high standards it sets for all our people
10 worldwide,” the Code permits “clients and other stakeholders [to] know what to expect of us wherever we work.”
35. On information and belief, KPMGI derives revenue from
KPMG LLP, including KPMG LLP’s New York offices, for its marketing and quality control functions. KPMGI has regular and pervasive contact into New
York and the United States. These contacts include KPMGI’s quality control review of audits in the United States and New York. KPMGI even reaches into
New York and the United States to require how KPMG LLP conducts its business from its audits to even the parameters of marketing the KPMG brand.
36. As part of its marketing function, KPMGI maintains a web site on which it represents to New York residents that it supports its American offices, and “ensures consistency of representation throughout each of its member firms through policies and regulations including submission to the KPMG quality review process.” KPMGI also advertises that member firms’ compliance with policies is “monitored through vigorous independent activities including reviews of independence, quality performance and risk management.” KPMGI “place[s] so much emphasis on bringing our shared values alive within member firms and helping to ensure that everyone follows our Global Code of Conduct”– the very quality controls that are the subject of this Complaint.
FACTUAL ALLEGATIONS
NEW CENTURY – KPMG LLP’S GROSSLY NEGLIGENT AUDITS
11 I. New Century’s Business: Subprime Mortgages and the Need for Proper Reserves
37. New Century was formed in 1995 as, primarily, an originator of mortgage loans. Throughout its twelve year existence – and without regard to whether it held those loans to collect interest, resold the loans to secondary lenders at a profit, or securitized them – New Century’s success, like that of all lenders, was tied to the quality of its loan portfolio and its reserve for risks.
38. Without proper reserves and reserve calculations, New
Century’s financial statements were misleading to the public and to New Century itself. First, if the correct factors were not included in the reserve calculation, New
Century could not properly plan for changes that might affect its business. It would continue to take on risks and expand its business when the prudent course would have been otherwise. Second, when those incorrect factors were used in the reserve calculation, the reserves were incorrect, causing the financial statements to be misleading to the public.
39. This dynamic came into particular focus for New Century when, beginning in the early part of this decade, it started to more aggressively pursue subprime mortgages. Subprime mortgages are characterized by higher risk to lenders. The risk can be increased by borrowers with marginal credit scores or insufficient income or by a higher ratio of loan-to-property value. Lenders assume this higher risk in exchange for higher interest rates, typically 2 percent higher than borrowers with better credit, higher down payments, or better documentation.
12 40. On the whole, the subprime mortgage industry grew exponentially in the early 2000s. The reasons for the growth of the subprime mortgage industry are many and include low interest rates and equity appreciation that attracted many new homebuyers, as well as a variety of newer mortgage arrangements – negative amortization, interest only mortgages, and hybrid or adjustable rate mortgages – that were designed to allow potential homebuyers who could not afford or qualify for conventional (lower interest rate) mortgages the opportunity to own a home.
41. Even in this fast-developing environment, New Century’s growth stood out. By 2003, the subprime mortgage market had become highly consolidated, with ninety-three percent of all subprime mortgages being originated by the twenty-five largest lenders. Of those, New Century was consistently among the four largest lenders and, in some time periods, was the second largest originator of subprime mortgage loans in the country.
42. The reasons for New Century’s explosive growth lay in its openly risky plan. As it repeatedly disclosed in public filings, New Century took risks in an already high-risk environment, risks that included pursuing fringe borrowers through temporarily lowered interest rates and “layering” its risks by taking on borrowers with multiple risk factors – for example, combining weak credit histories with incomplete or unsubstantiated income documentation and high loan to value ratios.
13 43. When New Century attempted to spread its risks by selling the mortgage loans it originated, some of that risk redounded back to New
Century. New Century’s sale agreements required New Century to repurchase loans in the event of certain conditions, such as early payment default (“EPD”), a default which occurs within several months following the loan’s sale, or in the event of a material breach of the representations or warranties made by the
Company regarding the loan’s characteristics and origination.
44. A key indicator of the health of New Century’s portfolio was the rate at which it was required to repurchase loans – in addition to having to take back bad loans and repay lost fees and interest, repurchased subprime loans were more difficult to resell, and were resold at significant discounts to their repurchase price.
II. KPMG LLP: New Century’s Auditor, Reviewer and Internal Control Tester
45. To account for the risks it was taking, and to provide comfort to creditors and investors to whom it disclosed these risks, New Century hired a professional, independent well-known certified public accounting firm to audit its financial statements. The auditor was KPMG LLP. KPMG LLP was retained when the company was formed in 1995, and served as New Century’s outside auditor until April 27, 2007, when it resigned, having issued twelve unqualified audit opinions on New Century’s financial statements. These opinions certified each of New Century’s consolidated balance sheets and the related consolidated
14 statements of income, comprehensive income, changes in stockholders’ equity and cash flows.
46. In addition to serving as New Century’s auditor, KPMG LLP served several other functions. In addition to its year-end audits, KPMG LLP conducted a review of New Century’s quarterly financial statements. As with its year-end audited financial statements, New Century’s quarterly financial statements were filed with the Securities Exchange Commission (“SEC”) for the public. Beginning in 2004, KPMG LLP also performed audits of the effectiveness of New Century’s internal control over financial reporting. In connection with these audits, which were required by the 2002 Sarbanes-Oxley Act, KPMG LLP was required to audit New Century’s assessment of the effectiveness of its internal control over financial reporting and identify any significant deficiencies and material weaknesses in control. As a product of these audits, KPMG LLP produced annual lists of deficiencies in New Century’s accounting controls that it recommended for correction.
47. As an auditing firm, KPMG LLP was aware that a company’s stakeholders rely on the company’s audits for assurance that the financial statements presented fairly, in all material respects, the financial condition of the company in conformity with GAAP. In the case of New Century, KPMG LLP should have been aware that GAAP compliant financial statements were a covenant requirement of the Company’s loan agreements, and that a failure to present its lenders with GAAP compliant financial statements would, among other
15 things, result in a default on the Company’s lines of credit on which it relied to conduct its business, causing irreparable harm to the Company. This is precisely what occurred.
48. The harm to New Century resulting from materially misstated financial statements should have been foreseeable to KPMG LLP at all times for which it was the Company’s auditor.
III. A Key Audit Risk in New Century’s Loan Portfolio: Loan Repurchases
49. As New Century disclosed in its public filings, when selling mortgage loans, the company was required to repurchase the loans it had sold or packaged or substitute another loan in the event of an EPD. This repurchase obligation was required by New Century’s loan sale agreements with secondary market lenders.
50. In a typical whole loan sale agreement, New Century agreed to repurchase loans if buyers defaulted in their first payment to the purchaser of the loan. Thus, generally, if a loan failed within the first 90 days of a secondary market lender’s purchase from New Century, the purchaser was contractually permitted to require New Century to take back the loan. In addition, the purchaser could require New Century to repurchase the loan if New Century was in default on any warranty it had made regarding the loan, regardless of when that breach was discovered.
16 51. Several aspects of the loan repurchase process affected New
Century, all of them negatively. When New Century repurchased loans, it realized expenses and losses. In addition to repaying the principal amount of the loan, it was also required to repay the premium that the lender had paid to purchase the loan, any interest due on the loan that had not been paid to that investor, and any losses that had been incurred. Further, as New Century acknowledged in its public filings, the repurchased loans were substantially impaired since “repurchased mortgage loans typically can only be financed at a deep discount to their repurchase price, if at all.” As a result, “they are typically also sold at a significant discount to the unpaid principal balance.”
52. Beginning in at least 2005, these loan repurchase provisions began to have an increasingly material, and ultimately overwhelming negative impact on New Century’s financial statements. As more borrowers defaulted on their loans, New Century was required to repurchase increasing numbers of bad loans that it would be forced to put back on its books, and to repay the purchasers the premiums and lost interest to which they were entitled. More broadly, the trend of increasing repurchases indicated that the most significant piece of New
Century’s business – its loan portfolio – was severely weakened.
53. KPMG LLP was fully aware of this trend. Its own workpapers note that the repurchases had more than doubled from 2004 to 2005, going from $135.4 million to $332.1 million. Even with this increase in the rate of repurchases — a clear indicator of weakness in the loan portfolio — KPMG LLP
17 failed to expand its procedures or testing of New Century’s reserves. Indeed, although KPMG LLP expressly acknowledged in its workpapers that the risk associated with the portfolio had gone from low to high, KPMG LLP did not expand its audit work in response to this increased risk.
IV. Accounting for the Loan Repurchases: The Loan Repurchase Reserve
54. The increase in loan repurchases should have been accounted for in New Century’s financial statements through its allowance for repurchase reserve (the “loan repurchase reserve”).
55. GAAP provides for the methods of accounting for loan repurchase reserves. Specifically, FAS 5, “Accounting for Contingencies,” requires the establishment of a loan repurchase reserve for losses and expenses related to estimated repurchases. According to New Century’s financial statements, this amount is the “Company’s estimate of the total losses expected to occur” in connection with the loan repurchase exposure related to loan sales. The larger the reserve, the greater the volume of loans that New Century expected to repurchase.
56. The significance of the reserve was not lost on New Century, nor unknown to KPMG LLP. Indeed, KPMG LLP regularly participated in Audit
Committee meetings where it was questioned about the reserve calculations. For example, and as reflected in the July 26, 2006 Audit Committee meeting notes:
“[KPMG LLP Manager] Mr. Kim reported that KPMG was in the
process of reviewing the Corporation’s second quarter financial
18 information and that its review was primarily focused on the
accounting for the Corporation’s derivatives, allowance for loan
losses, repurchase reserves and residual interests. Mr. Sachs then
asked a question about the adequacy of the Corporation’s repurchase
reserves and Mr. Donovan [KPMG LLP] and Ms. Dodge
responded.”
57. KPMG LLP knew that the estimation of this loan repurchase reserve was a critical accounting policy and could significantly impact New
Century’s financial statements, and thus its business.
58. Nonetheless, KPMG LLP ignored its own work product, which indicated that New Century’s reserve estimation process was not well- organized or well-documented. Indeed, through KPMG LLP’s audits of New
Century’s internal controls in 2004 and 2005, KPMG LLP found that New
Century had internal control deficiencies because it had not adopted formal policies and procedures for the reserve estimation process. Based on these findings, KPMG LLP advised New Century to adopt such formal procedures and policies. When New Century did not take KPMG LLP’s recommendation and adopt formal policies and procedures, KPMG LLP — knowing of New Century’s inability to accurately estimate the reserve — did nothing to change its audit approach relating to the loan repurchase reserve.
V. KPMG LLP’s Failures –Backlog and Future Claims, Inventory Severity/LOCOM, and Hedge Accounting
19 59. Many of KPMG LLP’s failures are obvious and pervasive.
For example, and inexplicably, KPMG LLP never required New Century to account for interest recapture — the interest payments payable on repurchased loans that had not been paid by the borrower — in calculating an appropriate reserve. More ominously, the KPMG LLP audit team repeatedly was alerted to their errors, but consistently ignored the advice of their own expert personnel.
A. Backlog and Future Claims
60. The loan repurchase reserve that KPMG LLP audited failed to account for large numbers of loan repurchase claims more than ninety days old that were already known to New Century — and KPMG LLP — and logged into the company’s records (the “Backlog Claims”).
61. Purchasers looking to return loans to New Century gave notices that were received by New Century’s Secondary Marketing Department and assigned to different departments within New Century for evaluation depending on the basis for the claim. The request for repurchase could only be made if the default occurred within a time period set by the sale contract; however, the decision whether to repurchase the loan could take much longer. The decentralization within New Century for dealing with repurchase claims created a backlog of repurchase claims.
62. KPMG LLP ignored the Backlog Claims entirely. KPMG
LLP accepted a repurchase reserve calculation that assumed that all repurchases
20 were made within 90 days of the date New Century sold the loans and did not consider the Backlog Claims.
63. This assumption — and KPMG LLP’s purported testing of it
— are plainly faulty. KPMG LLP claims to have tested the company’s assumption that repurchases could only happen within 90 days of the date New
Century sold the loan in two ways. First, KPMG LLP says it reviewed the loan sale agreements to confirm that they required repurchase in the event of repayment defaults that occur within 90 days of purchase. Second, KPMG LLP claims it reviewed New Century’s repurchase logs which contained historical information about repurchases to confirm that repurchases generally were being made within
90 days of the date of sale.
64. If KPMG LLP in fact performed such tests, it did so in a grossly negligent manner. First, the loan sale agreements, which widely varied in terms, had different repurchase cut-off periods. Moreover, many requests remained outstanding beyond the 90 day cut-off period. Second, even a cursory review of the repurchased log would reveal that a material and growing number of
Backlog Claims — the claims existing from the sale of loans beyond 90 days — were becoming a substantial part of New Century’s business.
65. If KPMG LLP had done its job as an auditor, the problem with the loan repurchase reserve calculation would have been discovered before it caused hundreds of millions of dollars in damage. Because the loan repurchase reserve was calculated at least every quarter, if the formula had been correct, New
21 Century would have seen its loan repurchase reserve grow on an incremental basis.
Instead, KPMG LLP permitted New Century to improperly calculate the loan repurchase reserve until it was too late.
66. As increasing numbers of repurchase claims came in, the backlog of unresolved claims grew larger. By mid-2006, New Century had approximately $224 million of unresolved repurchase claims, of which approximately $170 million were more than 2 months old and approximately $75 million of those were more than 6 months old.
67. Backlog Claims were the largest component of the misstated loan repurchase reserve, and KPMG LLP was aware that they were not properly accounted for as early as the 2004 audit. On January 26, 2005, as part of that audit, KPMG LLP inquired of New Century for the reason in the “jump” in repurchased loans. New Century informed KPMG LLP at that time that the reason was that “many of the loans were from prior quarters and months leading to the increased volume and discount.”
68. Notwithstanding this information, KPMG LLP did nothing to change its audit approach and the company’s public filings brazenly announced that only claims from within the quarter are considered for purposes of calculating the loan repurchase reserve. Indeed, as part of its 2004 audit procedures, KPMG
LLP concluded that “based on the review of the Company’s repurchase log and conversations with management, it appears reasonable that the most recent 3 months of sales are at risk for repurchase.”
22 69. KPMG LLP agrees today that the Backlog Claims should have been reflected in New Century’s financial statements in the loan repurchase reserve.
B. Inventory Severity/LOCOM
70. In the second and third quarters of 2006, New Century removed the “inventory severity” component of the repurchase reserve calculation altogether. KPMG LLP now admits this resulted in a violation of GAAP.
71. KPMG LLP’s approval of this accounting policy is notable because the decision was based on KPMG LLP’s faulty advice that the loss was already accounted for in the company’s lower of cost or market (“LOCOM”) analysis.
72. In the second quarter of 2006, KPMG LLP’s audit manager decided that accounting for the loan repurchases as part of the reserve was in effect “double counting” and resulted in New Century being over reserved. New
Century was surprised by the changed view of the accounting but, undoubtedly because it would be reflected in a better looking financial statement, accepted
KPMG LLP’s advice.
73. In New Century’s accounting before the second quarter 2006 change, the inventory severity component of the repurchase reserve was reclassified to a valuation account to appropriately value loans held for sale at the lower of cost or fair value. After the second quarter 2006 change, the inventory severity factor was no longer used to effect this valuation. Because of the
23 interplay between New Century’s loan repurchase reserve and the inventory severity component of its asset valuation allowance, the discontinuance of the inventory severity factor as an element of the repurchase reserve resulted in a material overstatement of loans held for sale on New Century’s balance sheet.
74. Thus New Century, at the behest of KPMG LLP, dropped its inventory severity analysis in Q2 and Q3 of 2006. This change increased the overstatement in loans held for sale, which was already overstated to begin with because of offsetting losses against gains in two different loan portfolios – repurchased loans and other loans.
75. Again, KPMG LLP was alerted to the wrongness of its policy this time by its own audit staff. When KPMG LLP auditor Christina Chinn reviewed the repurchase reserve in connection with KPMG LLP’s second quarter
2006 review, she noticed that the inventory severity component of the reserve had been removed and asked for a memorandum from New Century discussing the basis for the removal. Rather than support her inquiry, the senior KPMG LLP audit manager told Chinn to “please do not ask the client regarding this anymore.”
In accordance with this directive no further analysis was performed in the second quarter of 2006.
76. New Century materially overstated its loans held for sale in
2005 and for the first three quarters of 2006, and KPMG LLP failed to properly apply GAAP to New Century’s accounting for loans held for sale in its 2005
24 reviews, its 2005 audit, and in its 2006 reviews of New Century’s financial statements.
C. Hedge Accounting
77. New Century used derivative instruments to manage its exposure to interest rate risks associated with its financing on mortgage loans held for sale, mortgage loans held for investments and residual interests.
78. The accounting and reporting standards for derivative instruments and hedging activities are governed by FAS 133, “Accounting for
Derivative Instruments and Hedging Activities.” FAS 133 requires, at the inception of the hedge, formal documentation of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge, the method which will be used to assess the effectiveness of the hedging derivative, and the measurement approach to determine the ineffective aspect of the hedge.
79. Due to the complexity of hedge accounting, KPMG LLP enlisted the help of its internal specialist group, Financial Derivatives Resources
(“FDR Specialists”) in the review of New Century’s accounting, policies and procedures of hedging activities.
80. During the 2005 audit, the FDR Specialists informed the audit team of numerous issues relating to New Century’s hedge accounting activities, including New Century’s lack of a comprehensive and effective set of policies and procedures, failure to account for certain interest rate lock commitments as
25 derivatives, inappropriate interest cash flow assumptions and lack of contemporaneous hedge documentation.
81. These issues fell on deaf ears. On the eve of filing New
Century’s Form 10-K for 2005, a disagreement regarding the company’s hedge accounting practices and documentation came to a head. John Klinge and Ray
Munoz, KPMG LLP’s FDR Specialists, held up KPMG LLP’s issuance of its audit report because they disagreed with KPMG LLP’s treatment of New Century’s hedge accounting.
82. For the year-end audit, Klinge and Munoz had been assigned to provide specialized expertise and quality control on the derivatives and hedging issues that arose in the context of the audit. Their primary task was to determine whether the company’s hedge accounting conformed with FAS 133.
83. As of March 15, 2006, Klinge still was not prepared to sign off on the FDR Review of the New Century Audit, having failed to receive appropriate documentation to determine if New Century’s accounting was proper.
84. Management pressured KPMG LLP to issue its opinion, notwithstanding the fact that KPMG LLP had not completed its audit work, so that the reason for any delay would not become public and New Century’s Form 10-K would be filed on time. KPMG LLP succumbed to the pressure and issued its opinion minutes before the Form 10-K was due and New Century timely completed its filing. Klinge was instructed by KPMG LLP to prepare a signoff memorandum in which he would express his approval.
26 85. KPMG LLP issued its audit report before the audit was completed. At the time the audit report was issued KPMG LLP did not know one way or the other whether New Century’s financial statements were fairly presented in all material respects with GAAP. In doing so, KPMG LLP violated the audit standards on evidential matter and on generally accepted accounting principles.
86. By acquiescing to the client and issuing an audit report with open issues, KPMG LLP was not independent. Therefore, the audit opinion filed with New Century’s Form 10-K was a nullity and violated auditing standards.
VI. The Residual Interest
87. New Century retained a residual interest in each of the securitizations it structured as sales. The residual interest represented New
Century’s right to future cash flows or assets that remained in the trust created for the securitization after the payment to senior interests. New Century’s income from and valuation of its residual interests depended on the securitized loan pool actually producing income. Thus, residual interests were directly related to the quality of the loans in the pool.
88. The Company relied on internally-created models to determine its residual interest in a particular securitization. Each securitization had a separate model.
89. Each month, the Secondary Marketing Department would populate each securitization models with actual data. The model then would be rolled forward from the prior month to calculate the current residual interest based
27 on various assumptions (including, most importantly, the prepayment rate, the loss rate, and the discount rate) that were built into the model at the outset. Changes to the assumptions affected the value of the residual interest.
90. If the models had been done correctly, the residual interest would have been identified correctly on an incremental basis, allowing the
Company to properly run its business.
91. The models were wrong. The models used the wrong discount rates, used stale information from the late 1990s to calculate prepayment rates and inexplicably assumed that the loans would be sold at par value if the securitization collapsed. Moreover, the assumptions in the models were undocumented and unsupported.
92. To audit the financial statements, KPMG LLP had to apply audit procedures to the models. KPMG LLP was grossly negligent in not detecting the errors, or when it did detect control deficiencies, not taking steps to protect the public and New Century. As was its practice, KPMG LLP was not skeptical of Management’s assumption underlying the models, but instead was a defender of management. KPMG LLP allowed the models to be used even though the discount rates were plainly too low and allowed Management to artificially increase asset values. Moreover, as discussed below, Management had dismal internal controls, and thus there was a lack of documentation to support
Management’s assumptions for the models. Nonetheless, KPMG LLP accepted and defended Management’s assumptions.
28 93. For example, in 2005 when experts within KPMG LLP found that the Company’s documentation of the discount rate used was insufficient and the discount rate was too low, the KPMG LLP audit team sided with Management and found the discount rate to be reasonable.
94. In 2006, experts within KPMG LLP tried again, and again the
KPMG LLP audit team sided with Management instead of the public interest.
KPMG LLP’s audit team and Management’s interest won again, and no change was made.
95. KPMG LLP’s audit team knew that the problems were more than theoretical. KPMG LLP repeatedly discovered that the models used to calculate the residual interest valuations generated errors. KPMG LLP also had actual knowledge of errors in the data New Century was putting into the models.
This occurred at least as early as the 2004 audit.
96. KPMG LLP ignored these problems despite the fact that only a few years earlier, in 2000, a calculation error in the residual interest models led to a $70 million write down and New Century’s first loss in its history.
Management was determined to not let this happen again, and KPMG LLP knowingly or with a blind eye assisted Management.
97. In violation of auditing standards, KPMG LLP’s audit team did not exercise professional skepticism, which required KPMG LLP to adopt “an attitude that includes a questioning mind and a critical assessment of the audit evidence.” Moreover, auditing standards required KPMG LLP to test – not just
29 accept – Management’s assumptions, and to obtain sufficient evidence to support those assumptions.
98. Even when KPMG LLP repeatedly noted deficiencies in the models, and indeed New Century’s lack of any consistent criteria in the models,
KPMG LLP failed to take the necessary steps to ensure that the residual interests were fairly stated in accordance with GAAP.
99. A number of significant deficiencies existed with respect to
New Century’s residual interest valuation process, including:
(a) the absence of documentation describing how the residual
interest valuation models worked and how the assumptions used in
the models were established, revised or approved;
(b) a failure to increase the discount rate used to value residual
interests in 2005 and 2006 to reflect increased risk in the pools;
(c) a failure to adjust its prepayment assumption to reflect
changing market conditions despite the advice of the KPMG LLP
specialists to do so;
(d) the unilateral decision by Secondary Marketing in early 2006
to stop making changes to assumptions in pre-2003 securitization
models; and
(e) the assumption that the likely value of remaining loans in a
securitization at the time the trust was “cleaned up” or terminated
30 would be a “par value,” regardless of the pool’s delinquency status
or estimated market conditions.
100. These problems existed at least as early as 2004, and thus again KPMG LLP could have stopped the problem before these problems helped lead to New Century’s demise. However, by the third quarter of 2006, New
Century held residual interests in over thirty securitizations structured as sales that were reported on its balance sheet as $223 million.
101. In early 2007, New Century itself concluded that, when proper assumptions were applied in the valuation of its residual interests, its residual interests would need to be written down by approximately $90 million from the amounts at which they were valued as of September 30, 2006.
VII. KPMG LLP Negligently Audited New Century’s Internal Controls
102. KPMG LLP audited New Century’s internal control as required by Sarbanes-Oxley and PCAOB Auditing Standard No. 2, An Audit of
Internal Control Over Financial Reporting in Conjunction with an Audit of
Financial Statements.” Such audits over internal control were required by law in response to the Enron-era of financial reporting and accounting, when the public asked “Where were the auditors?” The law required KPMG LLP to audit and report on (i) management’s assessment of internal control and (ii) the effectiveness of internal control over financial reporting.
103. KPMG LLP identified internal control deficiencies in 2004, again in 2005, and again in 2006, but failed to take appropriate steps to protect the
31 public, the specific purpose of Sarbanes-Oxley. Moreover, despite KPMG LLP’s direct knowledge of the lack of proper internal control, it did not take appropriate steps in its audits of the financial statements to detect material misstatements due to error or fraud.
104. KPMG LLP found significant deficiencies with the internal controls of the exact same issues that caused the now admitted material misstatements in New Century’s financial statements, and ultimately caused New
Century to declare bankruptcy. KPMG LLP stated in its letters to New Century that “we considered internal control in order to determine our auditing procedures for the purpose of expressing our opinion on the consolidated financial statements,” demonstrating either gross negligence in its auditing procedures or simply false statements to it audit client.
105. For example, in 2004 KPMG LLP found a deficiency in the internal controls for the now admitted material misstatements arising from the calculation of residual value and allowance for loan losses. KPMG LLP found that “[m]anagement neglected to create adequate documentation” of its calculations that prevented assurances of “data integrity underlying the calculations.”
106. Nonetheless, in 2005 KPMG LLP only identified the risk of misstatement as “moderate.” However, in 2005 KPMG LLP again found thirteen control deficiencies relating to the residual interest valuation alone. Still, KPMG
32 LLP took no steps in its audits to correct for the lack of control, repeatedly giving in to Management’s wishes.
107. In 2006, KPMG LLP incredibly still found that
“[m]anagement does not have a regular, documented process in place to determine a threshold at which to adjust assumptions in the residual asset models.” Had
KPMG LLP done its job in 2004, the incorrect residual interest valuation would have been fixed before it helped cripple the Company.
108. Similarly, as KPMG LLP and New Century admitted, the internal controls for the calculation of the loan repurchase were inadequate and failed. As late as 2007, KPMG LLP declared that there was a “material weakness” in internal controls because “there were no controls in place to monitor the buildup of claims for repurchases during the year.”
109. Of course, KPMG LLP should have been aware of this backlog of repurchase claims, discussed above, at least as early as 2004. In connection with the 2005 audit, KPMG LLP was specifically informed in an email entitled “Repurchase Requests at 12/31/05,” that New Century “had outstanding repurchase requests of $188 mm at year end.” However, KPMG LLP accepted the flawed, 90-day back formula that estimated only $70 million repurchases.
110. Moreover, in KPMG LLP’s 2004 internal control audit,
KPMG LLP identified problems with the LOCOM internal control, including that there was no documentation of New Century’s review and approval of the
LOCOM analysis.
33 111. New Century publicly acknowledged in 2007 that there were material weaknesses and significant deficiencies in its system of internal controls over financial reporting in at least 2005 and 2006.
112. New Century also publicly reported in 2007 that the
Company’s consolidated financial statements for the year-end 2005 (the “2005
Financial Statements”) and interim financial statements for each of the first three quarters of 2006 (the “2006 Financial Statements”, and together with the 2005
Financial Statements, the “Financial Statements’) were not prepared in accordance with GAAP and were materially misstated.
113. Specifically, New Century advised, among other things, that the Financial Statements:
(a) failed to properly account for and report the repurchase
reserve in accordance with GAAP;
(b) failed to properly account for and report the lower of cost or
market (LOCOM) valuation adjustment for repurchased loans
in accordance with GAAP;
(c) failed to properly account for and report the valuation of
residual interests in accordance with GAAP;
(d) materially understated the repurchase reserve, materially
overstated the value of repurchased loans, and materially
overstated the value of residual interests;
(e) materially overstated pre-tax earnings; and
34 (f) should not be relied upon.
114. The deficiencies that existed during at least 2005 and 2006 in
New Century’s system of internal control over financial reporting included, but were not limited to, a failure to establish or develop:
(a) effective policies and procedures for calculating estimates,
including the repurchase reserve and the valuation of residual
interests;
(b) safeguards and controls to prevent the revision of or deviation
from accounting policies and related assumptions without
adequate supervision and review;
(c) safeguards and controls to insure the remediation of identified
internal control deficiencies;
(d) safeguards and controls to identify and process efficiently
repurchase requests; and
(e) safeguards and controls to ensure that the repurchase reserve
estimation process accounted for all outstanding repurchase
requests.
VIII. New Century’s Audited Financials Violate GAAP
115. All parties concede that New Century’s financial statements were not presented fairly in accordance with GAAP.
116. On February 7, 2007, a day before its 2006 fourth quarter and year-end results were scheduled to be released, New Century publicly announced
35 that it needed to restate its earnings for the first three quarters of 2006 due to its failure to account properly in accordance with GAAP for probable and estimable expenses and losses in its loan repurchase reserve. In particular, New Century explained that “the company’s methodology for estimating the volume of repurchase claims to be included in the repurchase reserve calculation did not properly consider, in each of the first three quarters of 2006, the growing volume of repurchase claims outstanding that resulted from the increasing pace of repurchase requests that occurred in 2006, compounded by the increasing length of time between the whole loan sales and the receipt and processing of the repurchase request.”
117. New Century further explained in that announcement that
“errors leading to these restatements constitute material weaknesses in its internal control over financial reporting for the year ended December 31, 2006.”
118. On March 2, 2007, New Century filed a notification of late filing with the SEC, in which it stated, among other things, that:
Although a full review is ongoing, the Company currently expects that the modifications to the allowance for loan repurchase losses will result in restated net income for the first three quarters of 2006 that is significantly lower than previously reported in the Company’s 2006 interim financial statements.
* * *
Although the Company’s mortgage loan origination volume increased in 2006 when compared to 2005, the Company’s results of operations for the quarter and year ended December 31, 2006 will reflect declines in
36 earnings and profitability when compared to the same periods in 2005. The Company currently expects that it will report a pretax loss for both the fourth quarter and full year ended December 31, 2006.
119. On March 12, 2007, New Century reported that the majority of its lenders had declared New Century in default and as a result had accelerated
New Century’s obligation to repurchase loans for a total of $8.4 billion in outstanding repurchase requests. New Century further disclosed that it lacked the liquidity to keep pace with repurchase requests. In addition, by the end of March, all of New Century’s lenders discontinued financing for the Company and New
Century had to cease its mortgage loan originations.
120. Following these public announcements, New Century’s stock fell by more than 90 percent and was delisted by the New York Stock Exchange.
121. On May 24, 2007, New Century publicly announced that the
Audit Committee had concluded “that it is more likely than not that . . . errors in the aggregate resulted in a material overstatement of pretax earnings in the
[Company’s] 2005 Financial Statements,” and that the Board had concluded “that the 2005 Financial Statements should no longer be relied upon.”
122. On April 2, 2007, New Century filed for bankruptcy in the
United States Bankruptcy Court for the District of Delaware to orderly liquidate.
123. On June 1, 2007, the Bankruptcy Court issued an order directing the United States Trustee to appoint an examiner to investigate the accounting and financial statement irregularities at New Century. Eight months
37 after his appointment, the Examiner released a 551-page final report that was filed with the Bankruptcy Court on February 29, 2008 (the “Examiner’s Report”).
124. The Examiner concluded that KPMG LLP was negligent in its audits. Moreover, the Examiner concluded that “the engagement team acted more as advocates for New Century, even when its practices were questioned by
KPMG LLP specialists who had greater knowledge of relevant accounting guidelines and industry practice.”
125. When the economic landscape began to change, New Century thus faced a shifting market without an independent public accountant, and with false assurances that it had resources it could use instead of reserve. 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.
VICARIOUS LIABILITY OF KPMGI FOR KPMG LLP’S GROSS NEGLIGENCE
I. KPMGI Is Vicariously Liable for the Loss Caused by KPMG LLP Because KPMG LLP Was KPMGI’s Agent.
38 126. KPMGI has the right to control KPMG LLP through agreements and policies that dictate how KPMG LLP conducts its business, including its audits.
127. Through these policies and agreements, including a membership agreement executed by both KPMGI and KPMG LLP, KPMGI manifests its understanding that member firms like KPMG LLP will act on
KPMGI’s behalf and subject to its control. By agreeing to the terms set forth in the membership agreement and by its actions, KPMG LLP accepts its role as
KPMGI’s agent.
128. To carry out its object – and to make money – KPMGI stresses the quality of its global network and the stringent standards and quality controls imposed and implemented by it on each of its member firms, including
KPMG LLP. KPMGI creates and fosters the belief that the audit reports issued by it and its member firms should be relied on because they are backed by the expertise of its global network, an expertise that KPMGI represents is ensured by the strict quality controls imposed and implemented by KPMGI.
129. KPMGI promises the public that it will strictly control the quality of member firms. For example, KPMGI states:
“To provide high quality services across the globe, KPMG recognizes
the critical importance of good governance in promoting our values and
performance.”
39 “KPMGI promulgates policies of quality control including
independence for its member firms’ audit practices . . . These policies
and their associated procedures were established to provide KPMGI
with reasonable assurance that its member firms comply with relevant
professional standards and regulatory requirements.”
“[KPMGI] has established policies and procedures to which member
firms must adhere to help ensure that the work performed by member
firm personnel meets the professional standards, regulatory
requirements and the member firm’s quality requirements applicable to
their respective Audit, Tax or Advisory services engagements.”
“To strengthen and enhance quality control, KPMGI and its member
firms will continue to provide training, technology based tolls, and
methodologies that contribute to quality audits.”
Audit engagement teams in all member firms follow the KPMG Audit
Methodology.
130. Specifically, the agreements and policies give KPMG LLP the right to put the KPMG logo and name on audited financial statements, including the audited financial statements for New Century at issue in this case.
If KPMG LLP fails to maintain the necessary level of standards, in performing audits, KPMGI can fire KPMG LLP.
131. KPMGI’s strict quality controls failed here. KPMG LLP’s negligent conduct of the New Century audits included a series of systemic failure
40 of standards and quality controls that damaged New Century – in other words, the standards and quality controls for which KPMGI was responsible.
132. In short, by failing to implement an audit procedure and conduct an audit, through its member firm, in accordance with auditing standards,
KPMGI failed New Century, its audit client, and is therefore responsible for damages suffered by New Century.
FIRST CAUSE OF ACTION (Vicarious Liability)
133. Plaintiff repeats and realleges paragraphs 1 through 132 of this Complaint as though fully set forth herein.
134. Pursuant to the agreements between the KPMGI and KPMG
LLP and the policies imposed by KPMGI and accepted by KPMG LLP, KPMGI acknowledged that KPMG LLP would act for it, and KPMG LLP accepted that undertaking.
135. KPMGI had the right to control KPMG LLP pursuant to the agreements between the KPMGI and KPMG LLP and the policies imposed by
KPMGI and accepted by KPMG LLP.
136. KPMGI had the right to make management and policy decisions affecting its agent, KPMG LLP.
137. KPMGI had the right to monitor KPMG LLP to determine whether it was complying with the policies and directions of KPMGI.
138. KPMGI had the right to terminate KPMG LLP.
41 139. KPMGI had the power to direct the policies and practices of
KPMG LLP every day it operated.
140. KPMG LLP therefore is KPMGI’s agent, and KPMGI is liable for the harm caused by KPMG LLP.
SECOND CAUSE OF ACTION (Deceptive and Unfair Business Practices)
141. Plaintiff repeats and realleges paragraphs 1 through 140 of this Complaint as though fully set forth herein.
142. KPMGI intentionally engaged in deceptive and unfair business practices. KPMGI promised to strictly control its agent KPMG LLP to entice the public, including consumers, its clients and New Century to use KPMG
LLP’s services.
143. KPMGI had a public duty to direct the policies and procedures of KPMG LLP, the certified public accountants KPMGI required to follow its audit and independence policies.
144. KPMGI knew that its promises were false when made.
145. KPMGI broke its promises and breached its public duty by failing to strictly control the quality of KPMG LLP’s audits, including the audits of New Century, harming the public interest.
146. As a proximate cause of KPMGI’s unfair business practices,
New Century was damaged.
42 PRAYER FOR RELIEF
WHEREFORE, Plaintiff respectfully requests judgment against
Defendant, under all applicable causes of action, as follows:
1. actual compensatory and consequential damages in an amount to be
proven;
2. rescission or rescissory damages;
3. restitution;
4. treble damages;
5. punitive damages;
6. injunctive relief stopping KPMGI’s false and deceptive business
practices;
7. attorney’s fees and costs of this suit as allowed by law;
8. pre-judgment and post-judgment interest as allowed by law; and
9. such other and further legal and equitable relief as the Court deems just
and proper.
43 JURY DEMAND
Plaintiff hereby requests a trial by jury on all claims in this
complaint.
Dated: April 1, 2009 Respectfully submitted,
Emily Alexander (EA-3946) THOMAS ALEXANDER & FORRESTER LLP 14 27th Avenue Venice, California 90291 Telephone: (310) 961-2536 Facsimile: (310) 526-6852
Attorneys for Plaintiff THE NEW CENTURY LIQUIDATING TRUST AND REORGANIZED NEW CENTURY WAREHOUSE CORPORATION, by and through Alan M. Jacobs, Liquidating Trustee and Plan Administrator
44