Missal Report Documents New Century Predatory Lending Even After General Counsel Warned Against It — Borrowers May Have Cause of Action Against Auditor KPMG

Report: New Century’s GC Warned Managers of Subprime Danger

Sue Reisinger
Corporate Counsel
March 31, 2008

Listening to its general counsel might well have saved New Century Financial Corp., once the nation’s second-largest subprime mortgage lender, from plunging into bankruptcy a year ago.

That’s one lesson from a 581-page report filed Wednesday by Michael Missal.A partner at Kirkpatrick & Lockhart Preston Gates Ellis, Missal was appointed by New Century’s bankruptcy trustee to investigate the company’s problems. Missal wrote that former New Century general counsel Stergios “Terry” Theologides recognized the high risk of subprime mortgages and warned senior managers about it in a memo in the fall of 2004. But no one paid attention.

Theologides, who left the company last September, could not be reached for comment. A New Century spokesman said in a statement, “The company is pleased that the examiner’s report is completed and that we can take the next steps of confirming the plan of liquidation, substantially concluding the bankruptcy process.” The Irvine, Calif.-based lender filed for Chapter 11 protection in April 2007.

Missal’s report explains that New Century evaluated its borrowers on the basis of their ability to make loan payments at an initial teaser rate. When the rate eventually increased, borrowers were hit with what Theologides’ memo termed “sticker shock.” If they couldn’t pay the increase, they would have to refinance their mortgages in what was becoming a tighter credit market. “We should not be making loans where the inability to refinance after two years leaves the borrower at very high risk of default,”Theologides wrote in the memo, which is included in Missal’s report.

Yet New Century continued doing just that. Missal primarily targets the lender’s senior management for engaging in “significant improper and imprudent practices” from 2005 to early 2007. But his report also points outthat Theologides was a member of the senior management group that decided to keep offering risky loans, as well as a member of its compliance committee that oversaw faulty company practices.

Asked about Theologides’ role in the case, Missal says the general counsel”was very much a part of senior management and certainly had influence within the company.” Missal, who also served as chief examiner in the Worldcom Inc. bankruptcy, declined to elaborate and said the report must speak for itself.

But one attorney close to the case, who asked not to be named, says New Century was clearly in “a situation where the lawyers raised some of the right questions, but never followed through, never pushed hard.”

This source says Theologides and other senior managers at New Century sensed that things were not going well, but felt no urgency to change what they were doing. “It was a ticking time bomb,” he says.

Missal’s report also links Theologides — as well as the company’s outside counsel, O’Melveny & Myers — to the lack of a proper process to handle disclosure issues. (Theologides was a former associate at O’Melveny before he joined New Century.) And the report criticizes the company’s inadequate disclosure of its risks in public filings, adding that O’Melveny “was heavily involved in discussions concerning what risk factors to include in the company’s filings and in drafting risk factor disclosures.”

Missal also blamed O’Melveny for a lack of cooperation with his investigation, and for “seeming adversarial” at times. For example, the report says New Century “unreasonably withheld … hundreds of thousands of important documents.” Missal also scolded O’Melveny for meeting with an unidentified senior officer to prepare him for an interview with Missal,even though O’Melveny was not representing this former officer. An O’Melveny spokesman could not immediately be reached for comment.

A large portion of Missal’s report also criticizes the accounting firm KPMG for condoning improper practices that led to significant errors in New Century’s financial statements for 2005 and 2006. On Wednesday, KPMG spokesman Dan Ginsburg told The American Lawyer, a sibling publication of Corporate Counsel, that the auditing firm “strongly disagrees” with the report’sconclusions concerning KPMG.

Missal ends his report by discussing what legal actions New Century’s bankruptcy trustee or others may take. First, Missal says KPMG may be liable for damages “for professional negligence and negligent misrepresentation.“Second, Missal says a lawsuit may recover bonuses and other compensation paid to officers that were tied, directly or indirectly, to the company’s misstated net income. These include quarterly performance-based bonuses,which Theologides and others received.

Third, Missal’s report says there is a question “with respect to whether actions or inaction on the part of individual officers or directors may give rise to potential causes of action.” Such a suit would shed more light on what Theologides and senior management did, or didn’t do, after the general counsel’s 2004 warning of “sticker shock” risk.

2 Responses

  1. Intent. This shows that if you have evidence of misrepresentation (false representation, concealment, or nondisclosure), you might be able to use this to show:

    – knowledge of falsity (“scienter”)
    – intent to defraud (to induce reliance)
    – justifiable reliance (they were a very large lender who you could “trust” to do the right thing)

    If you have all of the above and were damaged, you can probably plead fraud.

    Disclaimer: I am not an attorney and this is not legal advice.

    Dan Edstrom

  2. Of course its the lenders fault. The borrowers did not give themselves $200k checks. Greedy lenders coupled with shady lending practices = the perfect storm. Nice post though, check my site out at http://www.refinancingcondo.com for more information!

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