KPMG And New Century – Down The Legal Rabbit Hole

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An article in Law.Com, dateline March 10, updates us on the bankruptcy examiner’s report for New Century and what it may tell us about potential claims against KPMG, the former auditor.

There are shades of the Refco bankruptcy examiner conflict issue that limited his ability to consider claims against PwC in that case. In both cases, in deference to either the law firms or the difficulty (?) of the companies in finding independent law firms in these situations, the judges looked the other way at the conflicts.

But, in this case I have to ask… After Enron and Sarbanes-Oxley, audit firms have been restricted from and extremely skittish in acting as both auditor (giving opinions on the accounting treatment of transactions) and advisor to clients on that same accounting treatment. We have explored in a previous post the phenomenon of firms like Huron Consulting and FTI Consulting, firms that are independent and can both advise on GAAP and conduct investigations without the significant independence issues as the Big 4.

Did KPMG, as auditor, really advise on the accounting treatment or only act as an auditor, and review and attest to management’s choices? Whose responsibility is it to inform the Board and/or the Audit Committee of the Board of significant accounting changes? Surely in this post-SOx environment, it is the auditor’s role to attest that management has fully informed the Board, but not to be the first one to do it.

SAS No. 61, Communication with Audit Committees

SAS No. 61, Communication with Audit Committees (AU sec. 380), 1/ requires an auditor to communicate certain matters to the audit committee in connection with an audit of financial statements. SAS No. 61 applies to companies that have an audit
committee and to all SEC engagements, as defined in the standard. SAS No. 61 requires the auditor to communicate a number of items to the audit committee during the course of the financial statement audit, including the following–

• The auditor’s responsibility under generally accepted auditing standards. The auditor is required to communicate the nature of assurances provided in an audit, as well as the level of responsibility he or she assumes under generally accepted auditing standards (“GAAS”). The auditor also is required to communicate the assertion that an audit is designed to provide reasonable, but not absolute, assurance about the financial statements.

• Significant accounting policies and unusual transactions. The auditor should determine that the audit committee is informed about: (a) the initial selection of accounting policies, (b) changes in significant accounting policies, (c) changes in the application of significant accounting policies, and (d) methods used to account for significant unusual transactions or emerging issues for which there is a lack of authoritative standards or support.

And, in retrospect, would it have done any good to inform the New Century Audit Committee? Did they have the financial expertise to independently evaluate such proposed changes? Is the issue really that the Audit Committee didn’t ask or didn’t care to ask the CFO about these issues on a regular basis and obtain competent, independent expertise in order to evaluate them?

KPMG may only be the deep pockets in this case, not the one at fault.

We shall see…

Examiner’s Report May Cast Light on Subprime Mess
Lawyers await findings on New Century Financial, which may illustrate challenges inherent in internal investigations business

A 500-plus-page tome about what went wrong at New Century Financial — the second biggest subprime lender in the country until its fast descent into bankruptcy last year — has been eagerly anticipated by lawyers across a swath of practice areas. The bankruptcy examiner’s report could be unsealed as early as this week, and plaintiffs lawyers looking for a solvent defendant will be attuned to parts of the document that deal with New Century’s auditors, KPMG. New Century announced in February 2007 its need to restate earnings, but didn’t detail what went wrong in the company’s finance department.

According to lawyers familiar with the situation, the audit committee of New Century’s board was not told about accounting changes at the company that eventually contributed to the need to restate earnings. However, New Century’s regular auditor, KPMG, was involved in the accounting changes alongside finance department personnel, these lawyers say. …Events surrounding New Century have been closely watched because of its status as one of the first subprime casualties. But before the housing market fully tanked last summer, the lender’s audit committee did what many other companies have done when faced with possible wrongdoing by their employees: it called Heller Ehrman’s Michael Shepard.Shepard was asked to investigate the events surrounding the February restatement, along with some insider trading issues among top executives. From the outset, Shepard informed the audit committee of a conflict: Heller represents KPMG in other litigation, to the tune of half of 1 percent of its revenue, according to court documents. In his declaration, Shepard said he’d raised “the possible contention that Heller Ehrman’s relationship with KPMG would adversely affect objectivity of the investigation into issues involving KPMG, or at least the appearance of objectivity on those issues.”

Based on 2006 figures, KMPG represented $2.5 million in revenue for Heller. Though the terms of Heller’s engagement specified that the firm wouldn’t be able to advise on any possible claims the company had against the auditors, Shepard gave the committee his personal assurance the firm’s KPMG relationship would not limit his ability to “diligently and fairly pursue” all facets of the investigation, because his own reputation would be at stake…
Heller’s caveat about not being able to plot a litigation course against KPMG became academic once New Century entered bankruptcy. One of Missal’s central tasks is to recommend possible claims to creditors.

…the SEC will likely be interested in why KPMG personnel did not inform New Century’s audit committee about some of the accounting changes that took place at the company — and whether those accountants knew in-house finance staff hadn’t told the committee, either…