A recently unsealed bankruptcy court report on accounting issues at Irvine’s New Century Financial Corp. could become part of a criminal probe into the bankrupt subprime mortgage lender.
In the report, court-appointed examiner Michael Missal blamed New Century’s senior management and auditor KPMG LLC for creating a “ticking time bomb” of risky loans and improper accounting.
Missal’s preliminary report was issued in November with a final version submitted and made public late last month.
New Century, once the nation’s second largest subprime mortgage lender, spiraled in early 2007 when executives warned of a quarterly loss, projected a big drop in 2007 loans and said some results would need to be restated to fix accounting errors.
The company filed for bankruptcy in April 2007.
New Century, the poster child for the mortgage boom and subsequent meltdown, is under investigation by the U.S. Attorney’s Office in Santa Ana.
The probe includes once top executives, including former chief executives Brad Morrice and Robert Cole.
The U.S. Attorney’s Office declined to comment for this story, as did many representatives of local law firms due to work they have related to the New Century case or because of the sensitivity of the matter.
Other white-collar crime lawyers offered input on how an investigation into a company like New Century could play out.
Companies that do their own internal probes into accounting issues and that share information with federal regulators can end up avoiding indictments or harsh penalties, according to legal sources.
That’s been the case with scores of companies that did their own probes into stock options backdating. Out of some 150 that have been investigated by the government, only a handful has seen indictments, including Irvine’s Broadcom Corp.
But there won’t be any company probe into accounting issues at New Century, which is liquidating assets and winding down operations in bankruptcy court. The company didn’t even restate past results amid its rapid unwinding.
The demise of New Century as a company makes its former executives the likely focus of federal investigators, sources said.
The company’s senior management team could face criminal charges if prosecutors conclude they knowingly and willingly committed wrongdoing, they said.
In his report, Missal, a partner with Kirkpatrick & Lockhart Preston Gates Ellis LLP’s office in Washington, D.C., accuses New Century executives of mismanagement and raises the specter of possible fraud at the company.
In an interview last week, Missal declined to comment on whether he’s working with federal prosecutors looking into New Century. He was appointed as examiner in the case by Delaware’s bankruptcy court last year to look into allegations of mismanagement and possible wrongdoing.
Bad Risk Management
New Century executives failed to take steps to manage rising risks in making loans to borrowers with imperfect credit, Missal said in his report.
Instead of focusing on whether borrowers could pay their mortgages, members of New Century’s board and senior management team told Missal that their standard for loan quality was whether the loans could be packaged and sold as bonds to Wall Street, according to the report.
“New Century had a brazen obsession with increasing loan origination, without due regard to the risks associated with that business strategy,” Missal said.
The failed company was aware of an “alarming and steady increase in early payment defaults” on its loans done no later than mid-2004, he said.
Yet “senior management turned a blind eye to the increasing risks of New Century’s loan originations and did not take appropriate steps to manage those risks,” Missal said.
The company opted to “feed eagerly the wave of investor demands without anticipating the inevitable requirement to repurchase an increasing number of bad loans,” he said.
New Century went bankrupt after Wall Street buyers of loans packaged as bonds forced them back on the company as defaults started rising.
Missal’s report accuses New Century of at least seven wide-ranging improper accounting practices in 2005 and 2006 that resulted in misstatements of financial results for 2005 and the first three quarters of 2006.
The report contends that New Century calculated its buyback reserve incorrectly by not accounting for the growing backlog of claims related to older loan sales. In the company’s calculations, it also excluded interest that needed to be paid to investors when loans were repurchased.
“These critical omissions and changes were a violation of (generally accepted accounting principals),” Missal said.
KPMG, which served as New Century’s outside auditor since the company went public in 1997 to early 2007, allowed some of the improper accounting practices to continue, according to Missal.
Several people who Missal interviewed claimed that KPMG recommended the improper changes to New Century’s repurchase reserve calculation for its second and third quarters of 2006.
“New Century is ultimately responsible for the accuracy of its financial statements but KPMG bears responsibility at a minimum,” Missal said.
KPMG refutes Missal’s report.
“We strongly disagree with the report’s allegations concerning KPMG and we believe that an objective review of the facts and circumstances will affirm our position,” spokesman Dan Ginsburg said.
New Century’s accounting irregularities almost always resulted in increased earnings, according to Missal. But he said his investigation didn’t find evidence to conclude that New Century executives manipulated results.
Fraud?
Whether New Century’s accounting practices broke the law is up to prosecutors to determine. Missal’s report stops short of alleging fraud by New Century and KPMG.
Wayne Gross, head of the U.S. Attorney’s Office in Santa Ana until last year, declined to comment on New Century but weighed in on criminal probes into subprime mortgage companies. He now heads a white-collar criminal defense practice for the Costa Mesa office of Snell & Wilmer LLP.
The FBI’s announcement earlier this year that it opened 14 criminal investigations stemming from the subprime mortgage crisis may have some in OC wondering if they could face potential criminal liability, according to Gross.
“Orange County companies and professional service providers that have been involved in the subprime crisis need to be particularly careful in an environment where law enforcement, regulators and even bankruptcy examiners are focusing like a laser on perceived misconduct,” Gross said.
Missal, the lead counsel to the examiner in the 2002 WorldCom bankruptcy proceeding, said he hopes the media buzz surrounding New Century sends a message.
“Hopefully lessons can be learned from the New Century situation,” he said.
