In a what big four auditing firm KPMG would hope was just an April fools day prank, on April 1st a liquidating trust formed for the benefit of creditors in the New Century Financial bankruptcy has initiated a lawsuit against the company's auditor alleging damages in excess of $1 billion. New Century was one of the largest subprime lenders, until it restated its financial statements in early 2007 which caused the flow of credit required to originate loans to dry up. New Century filed for bankruptcy only a few months later, in April 2007. The bankruptcy court appointed an examiner, who investigated the reasons for New Century's collapse. The reportwas critical of KPMG's work.
KPMG is already a defendant in a securities class action lawsuit based largely on the bankruptcy examiner's report. Now, New Century's creditors are taking a run at the auditors in two different lawsuits. The first (here) was filed in California state court against KPMG LLP, the American audit partnership, that performed the audit work for New Century. The second (here) was filed in federal court in New York against KPMG International, the parent entity of KPMG LLP.
Aside from any factual issues about the audit work, there are several interesting legal issues that should impact the case. First, as the the California action, KPMG's agreement with New Century contained an arbitration clause. The complaint alleges that the clause contains a prohibition on punitive damages, which are illegal under California law and which therefore invalidates the entire arbitration provision. KPMG will certainly argue that even if the punitive damages clause in unenforceable, this should not invalidate the entire arbitration provision. Next, the liquidating trust has asserted claims for aiding and abetting breaches of fiduciary duty by New Century management. This claim may be barred by the legal doctrine of in pari delicto, which means that when two or more actors are at fault for the same damage one actor should not be able to sue the other. Advisers to company's have successfully asserted this defense early on in similar litigation. When a company's officers are alleged to have acted improperly, those actions typically get imputed to the corporation because it can only act through its managers. Therefore, the argument provides that the liquidating trust, which stands in the shoes of the corporation, cannot sue an outside adviser for participating in the same wrong that the corporation knew about. The argument has not been universally accepted, however.
The New York action is based on the legal theory that KPMG LLP is an agent of KPMG International. It effectively seeks to pierce the corporate veil of KPMG International, which can be done under certain circumstances. I think that the liquidating trust is fighting in uphill battle in this case.
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