Subprime Suit Accuses KPMG of Negligence

A trustee for New Century Financial claims KPMG partners ignored lower ranks' concerns about the lender's accounting for loan reserves.
Sarah JohnsonApril 2, 2009

Two complaints filed in federal courts yesterday claim that KPMG auditors were complicit in allowing “aggressive accounting” to occur under their watch at New Century Financial, the mortgage lender that collapsed two years ago at the beginning of the subprime-mortgage mess.

The plaintiff, a New Century trustee, alleges that misstated financial reports were filed with the audit firm’s rubber stamp because of its partners’ fears of losing the lender’s business. “KPMG acted as a cheerleader for management, not the public interest,” one of the complaints says. The trustee further accuses the firm of “reckless and grossly negligent audits.”

The plaintiff’s law firm, Thomas Alexander & Forrester LLP, filed one action against KPMG LLP in California and another in New York against KPMG International. With the authority to “manage and control” its member firm, KPMG International failed to “ensure that audits under the KPMG name” lived up to the quality control and branding value that “it promised to the public,” the lawsuit alleges.

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Similar litigation has been unsuccessful in holding international auditing firms responsible for their affiliated but independent members. For example, a lawsuit that Thomas Alexander filed against BDO Seidman in a negligence case involving Banco Espirito Santo’s financial statements resulted in a $521 million win for the plaintiff, pending an appeal. A case against BDO International is expected to go to trial later this year after an appeals court ruled that a jury should have decided whether it should have also been considered liable in the Banco case. Initially, a lower-court judge had dismissed the international organization from the case.

KPMG resigned as New Century’s auditor soon after the Irvine, California-based lender filed for bankruptcy protection in 2007. The auditor’s role in the firm’s failure has been questioned since then, by New Century’s unsecured creditors and the bankruptcy court.

In the new lawsuit, KPMG LLP is accused of not giving credence to lower-level employees’ concerns about their client’s accounting flaws and not finishing its audit work before  giving its final opinion — an account the firm disputes. In 2005, for instance, a partner was said to have “silenced” one of the firm’s specialists who had questioned New Century’s “incorrect accounting practice.” The partner allegedly said, “I am very disappointed we are still discussing this…. The client thinks we are done. All we are going to do is piss everybody off.”

Dan Ginsburg, KPMG LLP spokesman,says the above account is taken out of context and that the firm had followed its normal process; the firm’s national office had already reviewed and signed off on the issue being disputed.

Furthermore, Ginsburg says any claims that the firm gave in to its client’s demands “is unsupportable.” He adds, “any implication that the collapse of New Century was related to accounting issues ignores the reality of the global credit crisis. This was a business failure, not an accounting issue.”

New Century’s business was heavy on loaning subprime-level mortgages, but its accounting methods did not fully recognize the risk of doing so, the lawsuit alleges. It also says the firm violated GAAP by using inaccurate loan-reserve calculations by taking out certain factors to keep its liability numbers down and its net income falsely propped up. KPMG is accused of ignoring this GAAP violation and advising the firm on how to get around the rules. The complaint says this was a $300 million mistake.

In its most recent inspection of KPMG, the Public Company Accounting Oversight Board noted two occasions when the firm did not do enough audit work to be able to confidently trust its clients’ allowances for loan losses.