New Century Financial Corporation, Irvine, California, then the nation's second largest originator of subprime mortgage loans, announced on Feb. 7, 2007, that it would have to restate its financials for the first three quarters of 2006. Following this announcement, New Century's descent was dramatic and swift. Its stock price dropped precipitously, and the company disclosed on March 2, 2007, that it would not file its 2006 annual report on time. This revelation and other developments prompted increased margin calls by the company's lenders, accompanied by their refusal to provide further financing. As a result of these financial pressures, New Century stopped accepting loan applications on March 8, 2007, and the New York Stock Exchange (NYSE) delisted the company's securities a few days later. On April 2, 2007, less than two months after the restatement announcement, New Century and many of its affiliates filed for bankruptcy protection. Shortly thereafter, New York-based KPMG LLP resigned as the company's independent auditor. In early June 2007, the U.S. Bankruptcy Court for the District of Delaware issued an order granting the U.S. trustee's motion for authorization to appoint an examiner in the New Century bankruptcy proceeding. The court's order called for an examiner to, among other things, "investigate any and all accounting and financial statement irregularities, errors and misstatements" and to prepare a report of such findings. The order also required that the examiner identify any potential claims that the debtors' estates may have as a result of any improper conduct.
Pursuant to the court's order, the trustee appointed one of the authors of this article, Michael J. Missal, as examiner. K&L Gates LLP, Washington, D.C., served as counsel to the examiner in the investigation.
(The United States Trustee Program is a section of the Department of Justice that promotes the efficiency and integrity of the federal bankruptcy system. The U.S. trustee for a particular region monitors the conduct of the parties to bankruptcy proceedings in that region and seeks to further the public interest in the just, speedy and economical resolutions filed under the bankruptcy code.)
The examiner's goal was to conduct an investigation that was accurate, fair, timely, objective, credible and thorough. The investigation took approximately nine months and included the review of thousands of documents and 110 interviews of 85 witnesses. A final report was prepared and filed under seal on Feb. 29, 2008, pursuant to a further court order. The final report was released publicly on March 26, 2008.
The final report identified a number of significant improper and imprudent practices related to New Century's loan originations, operations, accounting and financial reporting processes. Among other findings, the final report disclosed that New Century had a "brazen obsession with increasing loan originations without due regard to the risks associated with that business strategy;" created a "ticking time bomb" by layering "the risks of loan products upon the risks of loose underwriting standards in its loan originations to high-risk borrowers;" made numerous exceptions to its underwriting standards; and used deficient appraisals.
The final report further revealed at least seven improper accounting practices in 2005 and 2006. Principal among them were incorrect calculations for the reserve for losses associated with the repurchase of loans previously sold to investors and the failure to value properly residual interests that the company held in off-balance-sheet securitizations.
As a consequence of these accounting failures, New Century understated its repurchase reserve by as much as 1,000 percent in the third quarter of 2006; reported a profit of $63.5 million in the third quarter of 2006, when it should have reported a loss; met analysts' earnings expectations for 2005 and the first quarter of 2006, when it should have announced earnings below expectations; and reported an increase in earnings per share of 8 percent for the second quarter of 2006 as compared with the same quarter of 2005, when it should have reported at least a 40 percent decline in earnings per share (EPS). …