Mortgage Meltdown

New Century Financial Creditors Seek Over Billion Dollars From KPMG

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.

SEC's Report On Mark-To-Market Under EESA Says FAS 157 Not A Major Factor In Financial Crisis Or Bank Failures

Section 133 of the EESA required the SEC to study mark-to-market accounting under FAS 157, and, in particular, whether to suspend or eliminate the rule.  The SEC staff issued the mandated  at the end of 2008.  The report clocks in at over 259 pages, and touches on all aspects of FAS 157.  My prior post on the FAS 157 issues is here.

Despite widely held belief that problems applying fair value accounting to illiquid assets was an important factor in spawning the financial crisis that led to the voluminous report, the Staff concluded that mark-to-market accounting did not play a major role in either the bank failures or the crisis at other financial institutions, including specifically Bear Stearns, Lehman and AIG.  The Staff concluded that liquidity pressures brought on by poor risk management and "concerns about asset quality" were the primary drivers of the financial crisis.  It seems to me, however, that these concerns about asset quality may have been concerns by investors as to whether banks and other financial institutions were properly valuing these illiquid mortgage-backed assets on their balance sheet.

The Staff reached itsconclusion that FAS 157 was not a major contributing factor primarily by looking at the recent financial statements of banks that failed and were taken over by the FDIC in 2008.  However, by focusing solely on those banks that were taken over by the FDIC and not considering other banks and financial institutions -- Wachovia and Citigroup come to mind -- that were either acquired before being taken over by the FDIC (Wachovia) or where the government injected sizeable capital to keepthem "healthy" (Citigroup,AIG, and others participating in the Capital Purchase Program), the study seems to have overlooked a large piece of the analysis.  As the report admits, the larger and more complex the financial institution, the more likely fair value accounting would have on the company's reported financial condition.  Therefore, it was these largest and most complex financial institutions that were both most impacted by fair value accounting and whose ailing financial health cascaded through the rest of the financial sector.

The staff also concluded, based "upon Staff observation through its prudential oversight function," that FAS 157 issues were not the "primarydriver" of the crisis; rather the Staff's "observations indicate that the liquidity positions of some financial institutions, concerns about asset quality, lending practices, risk management practice, and a failure of other financial institutions to extend credit appear to be the primary drivers."  The Staff specifically concluded that liquidity and a crisis in confidence in counter-parties, hedge funds, and traders led to the demise of Bear Stearns and Lehman Brothers.  The Staff stated that it believes "liquidity pressures" were the root cause of problems at other financial institutions, investment banks and AIG.

Finding that fair value accounting did not cause much of the problem, the Staff not surprisingly suggested only tweaking the current rules.  It made eight recommendations:

1) FAS No. 157 should be improved and not suspended;

2) Existing fair value and mark-to-market requirements should not be suspended;

3) Additional measures should be taken to improve the application and practice related to existing fair value requirements;

4) The accounting for financial asset impairments should be readdressed;

5) Further guidance is needed to foster the use of sound judgment in this area;

6) Accounting standards should continue to be established to meet the needs of investors;

7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and

8) There is a need to simplify the accounting for investments in financial assets.