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MILBERG WEISS BERSHAD
HYNES & LERACH
JEFFREY W . LAWRENCE (166806)
CHRISTOPHER P . SEEFER (201197)
100 Pine Street, Suite 260 0
San Francisco, CA 94111
Telephone: 415/288-4545
415/288-4534 (fax)
- and WILLIAM S . LERACH (68581)
401 B Street, Suite 1700
San Diego, CA 92101
Telephone: 619/231-1058
619/231-7423 (fax)
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BERNSTEIN LITOWITZ BERGER &
GROSSMANN LL P
ALAN SCHULMAN (128661)
12544 High Bluff Drive, Suite 150
San Diego, CA 9213 0
Telephone: 85 81793-007 0
858-793-0323 (fax )
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Attorneys for Plaintiffs
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UNITED STATES DISTRICT COURT
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NORTHERN DISTRIQT OF CALIFORNI A
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M. RICHARD ANDREWS and ) No .
JACKSONVILLE POLICE & FIRE PENSION )
FUND, On Behalf of Themselves and All ) CLASS ACTION
Others Similarly Situated, )
COMPLAINT AGAINST ERNST &
Plaintiffs, ) YOUNG, LLP FOR VIOLATIONS OF THE
FEDERAL SECURITIES LAW S
vs .
)
ERNST & YOUNG, LLP, )
Defendant .
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DEMAND FOR JURY TRIAL
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TABLE OF CONTENTS
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Page
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1 . INTRODUCTION ... ...... . . .... . . . ........ .......... . . . . .. ... ... ... . . . . . . . ... .. . . . ...... . ....... . ........... ........ .. . .. . .. ... 1
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II. JURISDICTION AND VENUE ... . . ...... . ... .. . ...... ...... . . . ..... . . ..... ...... . . . ..... . ...... . . ....... .. ............ .5
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III. THE PARTIES .... . ...... . . .. . . . ..... . . ..... . . ...... . . . .......... . . ...... . ...... . . ...... ....... ..... . . . ...... ...... . . . ..... . .. .....5
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IV . RELEVANT NONPARTIES AND CONFIDENTIAL WITNESSES .... ...... ...... .. . ...... . . .....7
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V. SUBSTANTIVE ALLEGATIONS . . ...... . .. ... . . . ........ .. .. . ..... . . . ...... ....... . . .. . . . . .... . . ..... . . .. . . ... . .. .. .9
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A . Description of the Company, Its Products and Business Strategy . . . ... .... ... .... . . .. .. . ...9
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VI. THE SCHEME TO DEFRAUD INVESTORS ... . . . . ...... . . . ..... . .... . . ...... . . . ..... . ...... . . ...... . . . .....12
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A . E&Y Falsely Certified NextCard's 2000 Financial Statements and Kne w
that NextCard's Delinquent Loans and Charge-Off Rates Were Materiall y
Understated . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 3
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B . E&Y Knew that NextCard Reported Materially False and Misleadin g
Financial Results Through Various Accounting Improprieties .. . . . ..... . . . ...... . . ...... . .1 5
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1 . E&Y Knew NextCard's Methodology for Establishing Loan Los s
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Allowances Caused the Company to Report Inflated Earnings . ...... . . ...... . .1 7
2 . E&Y Knew NextCard Improperly Classified Credit Losses a s
Fraud Losses to Understate the Charge-Off Rate ..... . . ... . .. . . .. .. . . . ... .. . . . ...... . .1 9
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3 . E&Y Knew NextCard, by Selling Delinquent Loans Just Befor e
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They Had to Be Charged Off, Understated Its Charge-Off Rate ..... . . ...... ..2 1
4. E&Y Knew NextCard Improperly Reduced the Charge-Off Rat e
Based on a New and Unproven Collection Policy . . .......... . . . ... . . . ...... . .... . . ...2 2
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5 . E&Y's Knowledge of the Accounting Improprieties Related t o
Loan Loss Allowances Is Shown by Their Alteration, Destructio n
and Falsification of Their Audit and Review Workpapers . . ..... . ...... . . ... . . ...24
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6. E&Y's Knowledge of the Accounting Improprieties Related t o
Loan Loss Allowances Is Also Shown by the Magnitude of th e
Additional Loan Loss Allowances Established by NextCard Afte r
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the Class Period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 5
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7. E&Y Knew NextBank Reported Inflated Earnings and Capital b y
Improperly Capitalizing Credit Card Acquisition Costs . ..... ..... . .. .... . . ........2 6
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8 . E&Y Knew NextCard Reported Inflated Earnings By Failing t o
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Write Down the Seller's Interest From Securitizations . . .... . ..... . .. .... . . .... . ...2 7
C. E&Y Knew NextCard Reported Inflated Regulatory Capital Ratios b y
Improperly Excluding Sold Loans from Risk Weighted Assets . .... . ..... . ...... . . ..... ...2 8
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COMPLAINT AGAINST ERNST & YOUNG LLP FOR VIOLATIONS OF THE - i FEDERAL SECURITIES LAWS -
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VII. E&Y TRIES TO COVER UP ITS PARTICIPATION IN THE FRAUD ...... ...... . ............30
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A. E&Y Provided Altered and Falsified Workpaper to the OCC to Concea l
Its Knowledge that NextCard's Publicly Issued Financial Statements Were
Materially False and Misleading . .... . . . .... ...... . . ...... . ..... .. . ........ . . . . . .... . . ............ ...... . . .30
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B . E&Y Withheld Information and Destroyed Information Subpoenaed b y
the OCC to Conceal the Prior Workpaper Alterations .. . . . ...... .. .... . ... .. . ...... ........ . ....38
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C . Trauger and Flanagan Have Admitted E&Y's Participation in the Schem e
to Defraud .... . . . .... . . .... ...... . ..... . . . .... .... . ..... . . . ...... . ..... . . . ..... . . . .......... . ... .. .. . ...... . ...... ..40
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VIII. E&Y's GAAS VIOLATIONS . . .. . . . ..... . . . .. .... ...... . . .. . .. ...... . . ...... . . ... . . . . . . ..... . ... . . ..... . ........ ...... .40
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IX . GAAP VIOLATIONS . . ... . . . .... . . .. . ... . . . ...... .... . . ..... . . ..... . . . .. . ... . .... . . .............. . ..... . . . ... ..... ...... ...45
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X . FALSE AND MISLEADING STATEMENTS DURING THE CLASS PERIOD . . . .... . . .49
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A . False and Misleading Statements Regarding NextCard's 1Q00 Results ..... ......... .49
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B . False and Misleading Statements Regarding NextCard's 2Q00 Results . . . . ..... . . . ...50
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C . False and Misleading Statements Regarding NextCard's 3Q00 Results . . . . . . ..... . . . .51
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D . False and Misleading Statements Regarding NextCard's 4Q00 and Fisca l
Year 2000 Results .. . . . .... ...... . . . . . . .. . . . ..... . ...... . . ...... . . . .. . . ...... . . ...... . .. ... . . . .... ..... . . . .... .. . . . .52
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E . False and Misleading Statements Regarding NextCard's 1Q01 Results . ...... . . ... . . .54
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F . False and Misleading Statements Regarding NextCard's 2Q01 Financia l
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Results ... . . . ..... . . ..... . . ... . . ..... . . . ...... . . .... . . . ..... ..... . . .. .... . . . ..... . .. .... . . ...... .... . . ..... . . ...... . . . .. . . .55
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XI . CLASS ACTION ALLEGATIONS ... . . . . ...... . .. ... . . . ...... . . ..... ..... . . . ...... . . .... . . . .. . . ..... . .. . ... . . . .....56
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CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG LLP FOR
VIOLATIONS OF THE FEDERAL SECURITIES LAWS -
-ii-
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1.
INTRODUCTION
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1 . This is a securities class action against Ernst & Young, LLP ("E&Y"), NextCard,
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Inc .'s ("NextCard" or the "Company") auditors, for its participation in a scheme to defraud
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NextCard shareholders in violation of the Securities Exchange Act of 1934 ("Exchange Act") . This
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action is brought under Fed . R . Civ . P . 23, seeking certification of a class of persons and entities who
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purchased NextCard securities between April 19, 2000 and October 30, 2001 (the "Class Period") .
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2. NextCard was an Internet-based issuer of credit cards that marketed its credit card s
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solely through its website, www.NextCard .com . The success of NextCard, like all credit card
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companies, was directly tied to the credit quality of the customers to whom it issued credit cards .
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The greater the credit quality of the cardholder, the more likely the company would be repaid and the
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greater chance that the credit card company would eventually be profitable .
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3. NextCard's credit quality was generally measured by three key, related criteria - loan
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delinquencies, the credit card charge-off rate and loan loss allowances. NextCard charged off loans
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once they became 180 days delinquent and used its historical charge-off rate to determine the
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amount of loan loss allowances it established to reserve for losses on its credit card loan portfolio .
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Thus, higher delinquencies led to higher charge-off rates, which required NextCard to establish
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additional loan loss allowances which decreased the Company's earnings . In every earnings release
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and Report on Form 10-Q and Form 10-K filed with the Securities and Exchange Commission
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("SEC"), NextCard reported delinquencies, charge-offs and loan loss allowances .
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4. Given that NextCard was an Internet-based credit card company, issuing credit card s
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to individuals almost instantly upon application, the risks that its customers would not pay thei r
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credit card balances was substantial . That risk increased because NextCard granted loans to
23 I subprime borrowers with FICO' scores below 660 to increase growth . Indeed, analysts repeatedl y
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' FICO scores refer to a test developed by Fair, Isaac and Company, which is widely used to
evaluate creditworthiness of borrowers. According to the Federal Financial Institutions Examination
Council ("FFIEC"), a FICO score of less than 660 is subprime . Exhibit (" Ex .") 1 at 14, n.7 . (All
Exs . are attached hereto . ) Subprime borrowers are generally defined as exhibiting significantly
higher default risk than traditional bank customers and often have tarnished credit histories .
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CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - - 1 -
1 I expressed concern over the increasing levels of delinquent loans and charge-offs reported b y
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NextCard during the Class Period and were continually reassured by NextCard that credit qualit y
3 l was under control.
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5. E&Y was NextCard's auditor from 1998, throughout the Class Period and into 2002 .
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Because E&Y knew that NextCard's business held significant credit risk, during its quarterly
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reviews and audits it evaluated NextCard's financial results paying particular attention to the loan
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delinquencies, charge-off rates and loan loss allowances that NextCard was reporting . From its
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audits and reviews of NextCard's financial statements, it is clear that E&Y knew that NextCard was
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reporting materially false and misleading financial results during the Class Period . As early as
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2Q00, E&Y knew that NextCard was improperly classifying credit losses as fraud losses and
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excluding these losses from the charge-off rate that was used to establish loan loss allowances . As a
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result, E&Y knew that NextCard understated the charge-off rate and loan loss allowances and
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overstated earnings . In addition, E&Y's workpapers reflect that as a result of its fiscal year 2000
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audit, E&Y knew that NextCard's charge-off rate as a percentage of managed loans was 4 .99% . In
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the 2000 Report on Form 10-K, however, E&Y certified NextCard's financial results which reported
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a charge-off rate of 2 .62% - nearly 50% less than what E&Y knew to be the true charge-off rate .
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Similarly, during the same audit, E&Y learned that the charge-off rate as a percentage of on-balance
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sheet loans was 8 .43% ; yet, E&Y certified that the reported number of 2 .55% was the accurate
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number even though it knew that number was false .
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6. During the Office of the Comptroller of the Currency's ("OCC") 2001 examination o f
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NextBank, N .A . ("NextBank"), E&Y learned that the OCC had discovered various accounting
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improprieties, challenged E&Y's audit and review procedures, and asked E&Y to provide certain
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working papers from its audit of NextCard's 2000 financial statements and its reviews ofNextCard's
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IQ01 and 2Q0I financial results . Rather than produce the working papers that would have shown
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E&Y's knowledge that NextCard had reported materially false and misleading financial results,
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E&Y destroyed, altered and falsified both hard and electronic copies of the working papers and
27 produced those altered versions to the OCC . For example, E&Y concealed their knowledge that
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NextCard had reported false delinquency and charge-off percentages by altering (and lowering) th e
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -2-
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percentages to match the false levels NextCard previously reported in its December 31, 200 0
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financial statements that E&Y certified as complying with Generally Accepted Accountin g
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Principles ("GAAP")
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7 . E&Y participated in the scheme to defraud by ( 1) falsely representing that
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NextCard's fiscal year 2000 financial statements conformed with GAAP, (2) falsely representing
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that E&Y's audit of NextCard's fiscal year 2000 financial statements was conducted in accordance
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with Generally Accepted Auditing Standards ("GARS"), (3) reviewing and approving NextCard's
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false and misleading quarterly financial statements before they were filed with the SEC, (4)
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concealing its knowledge that NextCard understated delinquencies and charge-offs and that
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NextCard was reporting artificially inflated earnings by failing to establish sufficient loan loss
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allowances and through other accounting improprieties, and (5) covering up and concealing from
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federal bank regulators and investors E&Y's knowledge of, and participation in, NextCard's
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fraudulent scheme by altering, destroying and falsifying their audit and review workpapers .
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8. E&Y has effectively admitted to its participation in the fraudulent scheme . Oliver G .
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Flanagan ("Flanagan"), an E&Y senior manager on the NextCard engagement, has pled guilty to
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corruptly obstructing the OCC's examination of NextBank in violation of 18 U .S .C . §1517 and has
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admitted that he withheld and destroyed responsive documents at the direction of Thomas C . Trauger
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("Trauger") for the improper purpose of concealing the prior alterations from the OCC . The
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Flanagan Plea Agreement is attached hereto as Ex . 2 and is incorporated byreference . Trauger, the
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E&Y audit partner on the NextCard engagement, has been arrested and charged with one count of
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corruptly obstructing the OCC's examination of NextBank in violation of 18 U .S .C . § 1517 and one
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count of knowingly concealing and covering up false entries in certain records and documents
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related to E&Y's annual audits and quarterly reviews of NextCard's financial statements with the
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intent to impede, obstruct and influence the investigation and proper administration of the
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investigation of NextCard by the SEC, in violation of 18 U .S .C . §1519 . A copy of the criminal
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complaint and the sworn affidavit of Federal Bureau of Investigation ("FBI") Agent Jason E .
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Richards ("Richards Aff.") is attached hereto as Ex . 3 and is incorporated by reference . Trauger also
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admitted to E&Y attorneys that he altered NextCard workpapers . The SEC has instituted tw o
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-3 -
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administrative proceedings - one, a currently pending, unsettled proceeding against Trauger and
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Michael Mullen ("Mullen"), an E&Y audit manager on the NextCard engagement, and the other, a
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separate, settled proceeding against Flanagan . Copies of the two administrative proceeding orders
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are attached hereto as Exs . 4 and 5, and are incorporated by reference .
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9 . On February 7, 2002, the OCC placed NextBank, NextCard's wholly owned bankin g
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subsidiary, into receivership and appointed the Federal Deposit Insurance Corporation ("FDIC") as
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receiver after determining that NextBank had experienced a substantial dissipation of assets,
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earnings and capital through unsafe and unsound practices and that there was no reasonable prospect
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for NextBank to become adequately capitalized without federal assistance . The failure of NextBank
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was one of the quickest bank failures in decades and will cost the FDIC between $300 and $350
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million, making it the most costly bank failure in 2002 . In November 2002, NextCard declared
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bankruptcy .
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10. The OCC concluded that the failure ofNextBank was caused by improperly managed
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growth of subprime loans to borrowers with FICO scores less than 660 that were masked through
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deficient accounting practices that caused earnings to be overstated by more than $88 million, assets
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to be understated by $1 billion and NextBank's regulatory capital requirement to be understated by
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more than $120 million . Specifically, the OCC determined that NextBank reported artificially
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inflated earnings and capital by (1) failing to establish more than $30 million of required loan loss
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allowances, (2) improperly capitalizing $35 .7 million of credit card loan acquisition costs, (3)
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improperly excluding more than $1 billion of securitized loans from NextBank's financial
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statements, and (4) overstating the Company's retained interest in securitized loans by $22 million .
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These accounting improprieties violated federal banking regulations, GAAP and the federal
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securities laws . E&Y directly participated in the scheme to defraud by making false and misleading
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statements and certifying NextCard's financial results when it knew they understated the amount of
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delinquent loans and charge-offs, information that analysts focused on and reported were critical
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indicators of the credit quality (i . e., collectibility) of the Company's loans and therefore, the overall
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viability of NextCard's Internet-based credit card business .
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CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -4-
1 II. JURISDICTION AND VENU E
2 11 . The claims asserted herein arise under §§ I0(b) and 20(a) of the Exchange Act , 15
3 U.S .C. §§78j(b) and 78t(a), and Rule lOb-5 . Jurisdiction is conferred by §27 of the Exchange Act,
4 and 15 U .S.C . §78aa .
5 12 . Venue is proper here pursuant to §27 of the Exchange Act . The acts and transactions
6 giving rise to the violations of law complained of occurred here .
7 111. THE PARTIE S
8 13 . During the Class Period M . Richard Andrews ("Andrews") and the Jacksonville
9 Police & Fire Pension Fund purchased shares of NextCard common stock, as set forth in the
10 certifications annexed hereto, and suffered substantial damages as a result of the violations of law
11 alleged herein . During the Class Period, NextCard had approximately 53 million shares of common
12 stock outstanding, which shares traded in an efficient market on the National Association of
13 Securities Dealers Automatic Quotation System ("NASDAQ"), NextCard operated through its
14 wholly owned banking subsidiary, NextBank .
15 14 . E&Y is an international accounting firm headquartered in New York, New York, with
16 offices throughout the world, including San Francisco, California . According to NextCard's proxy
17 statement filed with the SEC on May 7, 2001, E&Y served as NextCard's independent accountants
18 from 1998, and throughout its entire existence as a public company . According to the Company's
19 proxy, the Richards Aff. and Flanagan, during 2000 and 2001, E&Y provided the following services
20 to NextCard : (1) auditing the Company's consolidated financial statements for the fiscal year ending
21 December 31, 2000, (2) review of the Company's quarterly Reports on Form I0-Q that were filed
22 with the SEC, (3) and consultations on various tax and business process matters . See also Ex . 3, ¶4 ;
23 Ex . 2 at 3 (Flanagan Plea Agreement) . E&Y received fees of $283,500 for its audit and 10-Q review
24 services in 2000 and $180,647 of other fees including $85,078 of "other audit related fees ." On
25 January 23, 2001, following its review of NextCard's quarterly financial results and its audit of
26 NextCard's consolidated financial statements for fiscal year 2000, E&Y falsely represented that
27 NextCard's 2000 financial statements conformed with GAAP and that E&Y's audit was conducted
28 in accordance with GAAS . From their review of the Company's quarterly financial statements filed
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - - 5 -
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with the SEC, E&Y knew that NextCard reported materially false and misleading financial results .
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NextCard never disclosed the fees paid to E&Y for accounting services rendered in 2001 . The E&Y
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partner and some of E&Y's employees responsible for NextCard are identified below :
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(a) Trauger is a certified public accountant ("CPA") and was the primary audit
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partner assigned to the NextCard engagement . Trauger knew that NextCard's audited financial
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results for fiscal year 2000 did not conform with GAAP and, because E&Y certified NextCard's
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financial results which it knew were false, that E&Y's representation that its audit of NextCard's
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fiscal year 2000 financial statements was conducted in accordance with GAAS was false, In fact,
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Trauger knew the financial results reported by NextCard for fiscal year 2000, and 1 Q01 and 2Q01
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were contrary to the information contained in E&Y's workpapers . Trauger destroyed, altered and
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withheld information requested by the OCC to conceal E&Y's deficient audit and fraudulent
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scheme . On September 24, 2003, Trauger was arrested and charged with one count of corruptly
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obstructing the examination of a financial institution in violation of 18 U .S .C . § 1517 and one count
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of knowingly concealing and covering up false entries in certain records and documents related to
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E&Y's annual audits and quarterly reviews of NextCard's financial statements with the intent to
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impede, obstruct and influence the investigation and proper administration of the investigation of
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NextCard by the SEC, in violation of 18 U .S .C . § 1519 . The SEC has also instituted administrative
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proceedings charging Trauger with unethical and improper professional conduct as a result of his
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alleged alteration and destruction of documents .
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(b) Flanagan was employed as a senior manager by E&Y . Beginning in 2Q00 ,
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Flanagan was assigned to work as the senior manager on the NextCard engagement . Flanagan's
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supervisor on the NextCard engagement was Trauger. As a senior manager, Flanagan was
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responsible, among other things, for (1) reviewing work completed by members of the audit team,
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and (2) signing off on the audit work once it was finalized so that the electronic version of the audit
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could be archived in E&Y's automated workpaper system ("AWS") . On August 14, 2003, Flanagan
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entered into a Plea Agreement ("Flanagan Plea Agreement") with the United States Attorney
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wherein he agreed he was guilty of obstructing or attempting to obstruct the OCC's examination o f
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NextBank in violation of 18 U .S.C. §1517. Flanagan also settled administrative proceedings
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -6-
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instituted by the SEC whereby he was denied the privilege of appearing or practicing before th e
2 I SEC.
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(c) Mullen was an audit manager for E&Y . As detailed herein, Mullen also
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participated in the fraudulent scheme by altering and destroying E&Y workpapers requested by the
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OCC. The SEC has instituted administrative proceedings against Mullen .
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IV . RELEVANT NONPARTIES AND CONFIDENTIAL WITNESSE S
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15 . Plaintiffs have sued the NextCard defendants in a separate earlier proceeding . The
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following description of the NextCard defendants is provided to give context to E&Y's conduct an d
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to further elaborate on the scheme to defraud :
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(a) Defendant NextCard was an Internet-based provider of consumer credit . The
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Company offered an online credit approval system for a Visa card and provided interactive,
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customized offers for credit card applicants . NextCard operated in the United States and is currentl y
13 Ibankrupt .
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(b) According to the Company's SEC filings, (i) John V . Hashman ("Hashman")
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was the Company's Chief Financial Officer ("CFO") from August 1997 to March 2000, and
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president and CFO from March 2000 to August 2000 . From August 2000 through the end of the
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Class Period, Hashman was President, Chief Executive Officer ("CEO") and a director of th e
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Company ; (ii) Yinzi Cai ("Cai") was the Company's Senior Vice President for Decision Analytics
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from February 1999 to August 2000, the Company's general manager of the credit card business
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from August 2000 to February 2001 and the Company's President and Chief Operating Officer
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("COO") from February 2001 through the end of the Class Period; (iii) Jeremy R . Lent co-founded
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NextCard with his wife in June 1996 and served as the Company's Chairman of the Board of
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Directors and CEO from inception through August 2000, when he was appointed Chairman of the
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Board and Chief Strategy Officer ; (iv) Safi U . Qureshey was a director of the Company and a
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member of the audit committee and compensation committee ; and (v) Bruce G . Rigione ("Rigione")
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has been a director since March 1997 and was the Company's Senior Vice President of Business
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Development from July 1999 to August 2000 . From August 2000 through the end of the Class
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Period Rigione was the Company's CFO .
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
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16. Jason E . Richards ("Richards") is a Special Agent with the FBI who investigates
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white collar crime including securities fraud . He is a CPA and is familiar with GAAP and GAAS .
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Richards prepared an Affidavit dated September 24, 2003 setting forth E&Y's role in the fraudulent
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scheme in connection with NextCard . See Ex . 3 .
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17 . Confidential witness ("CW") I was a Vice President of Risk Management at
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NextCard from September 2000 until after the Class Period . CWI was closely involved with the
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underwriting process and credit guidelines that NextCard used to evaluate potential customers . CW 1
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is also knowledgeable about how NextCard calculated loan loss allowances and how the Company
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differentiated between credit losses and fraud losses . CW1 also was involved in several meetings
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with the OCC in 2000 and 2001 and has knowledge about the OCC's examination findings ,
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CW2 was a file transmission specialist at NextCard from 1999 until after the Class
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Period . CW2 was responsible for entering cardholder account write-off data into a Company
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database . CW2 received monthly email messages from NextCard's fraud manager and collections
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manager that provided the accounts to be written off. CW2 assigned a "reason code" to each account
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written off that indicated whether the write-off was a credit loss or fraud loss .
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19 . CW3 was a former Chief Marketing Officer through September 2000 .
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20 . CW4 was NextCard's former head of public relations at NextCard through Marc h
18 12001,
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21 . CW5 was a former NextCard manager throughout the Class Period . CW5's job
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responsibilities included, among other things, consolidating reports to reconcile loan loss reporting .
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In May 2001, CW5 prepared reports that were provided to the OCC detailing the number of
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customer accounts with FICO scores below 660. CW5 was also involved in a major re-pricing and
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penalty pricing initiative during 2Q01 whereby the Company increased the interest rates and late
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fees on all existing customer accounts . CW5 stated that the pricing initiatives were typically rushed
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through without the benefit of an analysis to determine what the response would be in order to
26
increase revenues in 2Q01 . CW5 stated that NextCard lost customers due to these actions .
27
22. CW6 was a NextCard operations planning manager through July 2000. CW6
28
repo rted to COO Tim Coltrell who repo rted to defendant Cai . CW6 stated that NextCard did not
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -8-
1 close customer accounts after a customer asked for the account to be closed . CW6 stated the delay
2 in closing customer accounts was done to increase the number of open accounts and that CW6
3 believed the practice was done to deceive shareholders into thinking the Company had more open
4 accounts .
5 23 . CW7 was a NextCard director of customer service or operations support throughout
6 the Class Period.
7 24 . CW8 was a NextCard collections representative throughout the Class Period . CW8
8 worked in the Company's collections department and was responsible for contacting delinquent
9 customers and fielding customer complaints . CW8 stated that customers complained about
10 NextCard increasing interest rates on their credit cards after an initial period during which the
11 interest rate was much lower .
12 V. SUBSTANTIVE ALLEGATION S
13 A . Description of the Company , Its Products and Business Strategy
14 25 . NextCard was an Internet-based provider of consumer credit cards . Unlike other
15 credit card originators, NextCard marketed credit cards solely through its website,
16
www .NextCard .com , believing it was positioned to take advantage of the exponential growth of
17 consumers using the Internet . Analysts following the Company reported, and NextCard represented
18 in its SEC filings, that NextCard operated in a "hotly competitive" industry where even established
19 companies like Capital One, BankOne, Chase, MBNA, and Providian were finding it difficult to
20 grow .
21 26 . To successfully compete against these companies and become profitable, NextCard
22 had to grow . In particular, NextCard needed to increase its credit card loans while keeping its costs
23 down and increase the number of accounts that it managed to achieve profitability . While there is no
24 back-end risk in selling products like books or CDs, where the customer pays for the goods when
25 they are received, credit card companies like NextCard must carry the risk burden of its customers
26 into the future . To be successful, a credit card company must issue credit cards to creditworthy
27 individuals who would use them and pay the charges and fees . Indeed, financial analysts evaluate a
28 company's credit card assets based on the credit quality of its receivables . In fact, one of the most
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -9-
1
critical measures of the successful growth of a credit card company is its "charge-off rate" - the
2
percentage of credit losses in relation to the overall loan portfolio . NextCard charged off credit card
3
loans once they became 180 days delinquent . Thus, delinquencies and the charge-off rate are strong
4
indicators of the profitability and viability of a credit card company since it informs investors of the
5 i quality and performance of the company's loans and lending strategy .
6
27. Thus, to be successful , NextCard had to guard against " adverse selection ," i.e.,
7
granting credit cards to non-creditworthy customers while it pursued its growth strategy . The risk
8
was even more pronounced for NextCard because it was solicited by customers that responded to its
9
Internet advertising where anyone could simply log on to the Internet and obtain a credit card
10
application . Historically, customers that solicited a credit card company for a card tended to have
11
much higher losses than customers solicited by the credit card company . The impersonal nature of
12
the Internet compounded these risks for NextCard.
13
28 . In its effort to achieve profitability and maintain credit quality, NextCard (1) pursue d
14
an aggressive Internet advertising campaign, (2) provided an easy and quick application process
15
whereby a potential customer could complete an application and receive a response within seconds,
16
(3) offered initial teaser rates on its credit cards, and (4) offered approved accounts other perks
17
including balance transfer services, customization of the face of the card according to personal
18
preferences, e-wallet services and NextCard rewards . Through strategic alliances with other
19
companies like Priceline .com and Amazon .com, the Company also offered cards to their customers .
20
NextCard represented that it controlled adverse selection risks by limiting approvals to applicants
21
with FICO scores above 700, maintaining sufficient loan loss allowances and segmenting accounts
22
by each advertiser to determine what advertising relationships were producing poor quality accounts .
23
29. NextCard completed its initial public offering on May 19, 1999, sold 6.9 million
24
shares of its common stock at $20 per share and raised net proceeds of approximately $127 million .
25
In September 1999, NextCard acquired Textron National Bank and renamed it NextBank . NextBank
26
was the first Internet-only credit card bank chartered by the OCC . NextBank's business plan
27
initially targeted low risk prime borrowers . Analysts reported that NextBank would enhanc e
28
NextCard's liquidity by providing it with FDIC insured deposits . On December 14,1999, NextCard
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - _10-
E
I completed a secondary offering and raised net proceeds of approximately $153 million by issuing
2 4 .5 million shares at $35 .94 per share .
3 30 . Although NextCard (through NextBank) had only begun to issue credit cards late in
4 the year, it was able to report growing numbers of credit cards and managed loans . By the end of
5 1999, NextCard appeared to be successful : accounts nearly tripled (increasing from 85,000 to
6 220,000) and the amount of managed loans went from $163 million to $416 million - a 155%
7 increase . However, NextCard's strategy of making loans to low risk prime borrowers, while
8 minimizing credit risk, resulted in low approval rates (approximately 20%) and prohibitively high
9 account origination costs which, in turn, hindered growth and profitability . Thus, even though
10 NextCard reported a 64% increase in accounts and a 55% increase in the amount of managed loans
11 in 4Q99 over 3Q99, analysts were still cautious because of NextCard's high acquisition costs and
12 creditworthiness issues .
13 31 . The interaction between high acquisition costs and credit risk was a significant factor
14 in the market's evaluation of NextCard . For example, on January 10, 2000, First Union Securities,
15 Inc . ("First Union"), analyst Meredith Whitney ("Whitney") downgraded the stock from "Strong
16 Buy" to "Hold" because its acquisition costs (advertising, application processing fees) had been
17 prohibitively high, making profitability difficult . She also noted that NextCard's inability to sign a
18 sub-prime alliance could force the Company to issue sub-prime credit cards on its own . Whitney
19 also noted that NextCard's alliances with Priceline .com and Amazon .com could squeeze NextCard
20 into lowering FICO scores to increase approval rates to avoid upsetting their alliance partners . CIBC
21 World Markets Corp . ("CIBC") analyst Vincent Daniel ("Daniel") mirrored those concerns in a
22 report issued on the same day . Daniel stated that the Company's recently announced co-branding
23 relationship with Priceline .com could be problematic because a large portion of Priceline .com's
24 customers had FICO scores below NextCard's standards, and because the acquisition cost per
25 Priceline .com customer would be high at $100 to $120 .
26 32 . Analysts continued to express concerns about credit risk . On January 28, 2000,
27 Whitney issued another report after NextCard's favorable conference call regarding 4Q99 and fiscal
28 year 1999 financial results . She maintained the "Hold" rating due to management's accompanying
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - - 11 -
1
announcement that it intended to enter the non-prime market and the Company's deteriorating credit
2
quality trends . CIBC analyst Daniel issued a report on January 27, 2000 which stated that charge-
3
offs and delinquencies on a 12-month lagging basis that had deteriorated to 9 .43% and 9.33% were
4
"well above industry standards," a "red flag" and "cause for concern ." All of these concerns resulted
5
in NextCard's stock price declining from $27-7/8 on December 31, 1999 to $15-7/8 on March 31,
6
2000 - a 43% decline.
7
VI. THE SCHEME TO DEFRAUD INVESTORS
8
33 . NextCard could only increase growth by lowering required FICO scores and making
9
loans to subprime borrowers . NextCard reported inflated earnings by intentionally understating its
10
loan loss reserves on its increasingly risky credit card loan portfolio . NextCard also engaged in other
11
accounting improprieties, including the improper capitalization of loan acquisition costs, the failure
12
to write down the Company's retained interest in securitizations and improperly excluding more than
13
$500 million of securitized loans from risk weighted assets, that caused NextCard and NextBank to
14
report inflated earnings and capital . In order to convince the market of the Company's financial
15
viability, NextCard had to alleviate concerns over the credit quality of its credit card customers and
16
reduce acquisition costs so that it could become profitable . However, NextCard lied to the market
17
by falsely representing that the credit quality was under control and by reporting materially false and
18
misleading financial results through fraudulent accounting practices .
19
34. The fraudulent accounting scheme overstated earnings and capital, led to the seizure
20
ofNextBank in February 2002 and required more than $88 million accounting adjustments . Because
21
the market placed great emphasis on NextCard's financial results, particularly the credit quality of its
22
credit card receivables as measured by delinquencies, loan charge-offs and loan loss allowances, its
23
scheme to defraud was accomplished with E&Y's knowing participation in the scheme . E&Y knew
24
of the false financial results and furthered the scheme by providing a (false) "clean" audit opinion for
25
2000 and by reviewing and approving the Company's false quarterly financial results .
26
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -12-
21,
A. E&Y Falsely Certified NextCard' s 2000 Financial Statements and
Knew that NextCard' s Delinquent Loans and Charge-Off Rates Were
Materially Understate d
3
35 . On January 23, 2001, E&Y issued the following opinion on NextCard's 1999 an d
4
2000 financial statements that was included in NextCard 's Report on Form 10 -K for the year ending
5
December 31, 2000 filed with the SEC on April 2, 2001 .
6
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
7
The Board of Directors and Shareholder s
8
NextCard, Inc . and subsidiarie s
9
We have audited the accompanying consolidated balance sheets of NextCard, Inc .
and subsidiaries as of December 31, 2000 and 1999, and the related consolidated
statements of operations, changes in shareholders' equity, and cash flows for each of
the three years in the period ended December 31, 2000 . These financial statements
are the responsibility of NextCard, Inc .'s management . Our responsibility is to
express an opinion on these financial statements based on our audits .
10
11
12
13
14
15
16
17
18
19
We conducted our audits in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement . An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements . An audit also
includes assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation . We
believe that our audits provide a reasonable basis for our opinion .
In our opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of NextCard, Inc. and
subsidiaries at December 31, 2000 and 1999, and the consolidated results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2000 in conformity with accounting principles generally accepted in
the United States.
20
Isl ERNST & YOUNG LLP
21
San Francisco , California
January 23, 200 1
22
23
24
25
26
27
28
36. The following false representations were contained in note 8 to the consolidate d
financial statements:
At December 31, 2000, NextCard's managed credit card loan portfolio of $1,312 .3
million was comprised of $528 .1 million in reported credit card loans and $784 .2
million in off-balance sheet credit card loans. At December 31, 2000, .NextCard's
31 plus days credit card loan delinquencies on a reported and managed basis were
$30.0 million, or 5.46%, and $51.4 million, or3.92%, respectively. NextCard`s net
charge-offs for the year ended December 31, 2000, on a reported and manage d
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-13-
I basis were $14.2 million, or 2.55% of average reported credit card loans, and $22 .4
million, or 2 .6.2°%, of average managed loans, respectively.
2
37 . On January 24, 2001, the day after E&Y issued its audit opinion on the Company's
3
fiscal year 2000 financial statements, NextCard issued a press release announcing the Company's
4
4Q00 and fiscal year 2000 financial results . It was reported in the press release that the delinquency
5
rate on total managed loans was 3 .92% as of December 31, 2000, net charge-offs were $22.4 million
6
or 2 .62% of average managed loans in fiscal year 2000 and the net charge-off rate was 3 .1% of
7
average managed loans in 4Q00 . NextCard reported the following in their January 24, 2001 press
8
release and Report on Form 10-K filed with the SEC on April 2, 2001 :
9
2000 3Q,00 4000 FY00
10
Delinquency Rate 2 .68% 3 .30% 3 .92% 3 .92%
11
Net Charge-Offs $4,080 $6,426
$9,347'
$22,407
12
Average Managed Loans $737,275 $961,983 $1,206,397 $858,105
13
Net Charge-off Rate 2 .21% $2 .67% 3 .1% 2 .62%
14
38. Before they were altered, E&Y's 2000 audit workpapers showed that E&Y knew
15
NextCard's delinquent loans and charge-offs were materially false and misleading because they were
16
substantially higher than the amounts reported by NextCard (and certified by E&Y) as of December
17
31, 2000 .
18
As Reported E&Y's Workpagers
19
Loans 30 or more days
20 delinquent as a % o f
managed loans 3 .92% 4.23%
21
Loans 60 or more days
22 delinquent as a % o f
managed loans 2 .48% 5 .35%
23
Charge-offs as a %
24 of Managed Loans 2 .62% 4 .99%
25 Charge-offs as a %
of on-balance sheet
26 loans
2 .55% 8 .43 %
27 39 . The amount and percentage of delinquent loans and charge-offs were particularly
28 important to NextCard's investors because they impacted reported earnings and were important
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -14-
1 indicators of the credit quality (i.e., coltectibility) ofNextCard's credit card loans . Indeed, analysts
2 that followed NextCard reported that credit card assets were valued based on the credit quality of the
3 receivables . Analysts also expressed concern over the increasing levels of delinquent loans and
4 charge-offs reported by NextCard during the Class Period . NextCard repeatedly assured investors
5 that it applied "stringent credit and risk management standards" to its credit card loan portfolio and
6 that the loan loss allowances established by the Company reflected its "conservative approach to
7 loan reserves."
8
B . E&Y Knew that NextCard Reported Materially False and Misleading
Financial Results Through Various Accounting Improprieties
9
40. E&Y also falsely certified NextCard's 2000 financial statements and reviewed and
10
approved NextCard's quarterly financial statements in 2000 and 2001 when they knew NextCard
11
was reporting inflated earnings by failing to establish sufficient loan loss allowances and through
12
other accounting improprieties .
13
41 . GAAP requires lenders like NextCard to record a loan loss allowance if it is probable
14
that it will incur a loss on the loan and the amount of the loss is estimable . SFAS 5 . To establish a
15
loan loss allowance, NextCard's financial statements include a "provision for loan losses" expense
16
which reduced NextCard's net interest income after provisions for loan losses and earnings . Loan
17
loss provisions and net interest income after the provision for loan losses were key indicators of the
18
credit quality of NextCard's credit card loans and also impacted the Company's earnings .
19
42 . During the Class Period NextCard reported the following financial results (in 000s) :
20
Z _Q0__0
21
22
3Q00
4000
FY00
Interest Income $17,194 $24,529 $23,846 $81,378
Interest Expense $7,473 $11,934 $11,105 $37,156
23
Net Interest Income $9,721 $12,595 $12,741 $44,222
24
Provision for Loan Losses $9,563 $16,134 $22,843 $57,141
25
Net Interest Income after
26 Provision for loan losses $158 ($3,539) ($10,102) ($12,919)
27 Non-interest income $8,351 $23,760 $32,351 $77,312
28 Non-interest expense $32,972 $40,479 $41,687 $146,24 9
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - - 15 -
Net Income/(Loss) ($24,463) ($20,258) ($19,438) ($81,856)
EPS
($0.46) ($0.38) ($0 .37) ($1 .56)
,110_1
2001
300 1
Net Interest Income
$16,335
$15,255
$19,655
Interest Expense
$9,425
$8,097
$8,36 3
Net Interest Income
$6,910
$7,158
$11,29 2
Provision for loan losses
$20,049
$18,509
$55,53 4
8
Net Interest Income after
9
Provision for Loan Losses ($13,139) ($11,351) ($44,242)
10
Non-interest income $36,996 $36,521 $34,891
11
Non-interest expense $40,482 $39,535 $43,795
12
Net Income/(Loss) ($16,625) ($14,365) ($53,146)
13
EPS
($0 .31) ($0 .27) ($1 .00)
14
43 . E&Y audited NextCard's fiscal year 2000 financial results and represented they
15
complied with GAAP . E&Y also reviewed and approved the Company's quarterly financial results
16
before they were filed with the SEC .
17
44. In fact, E&Y knew that NextCard's financial results were materially false and
18
misleading and were achieved by manipulating NextCard's accounting . In particular, E&Y knew
19 1 NextCard understated the loan loss provision expense (and overstated earnings) through various
20
improprieties . According to CW1, the Company determined the loan loss provision expense by
21
calculating a rolling average percentage of historical credit loss write-offs and applying that
22
percentage to the current portfolio . The Company also represented in the notes to its fiscal year
23
2000 audited financial statements that historical charge-offs were used to evaluate the adequacy of
24
loan loss allowances, and that it charged off loans once they became 180 days delinquent except for
25
an account in bankruptcy which was charged off within 60 days of receipt of notification of the
26
bankruptcy filing . See fiscal year 2000 Report on Form10-K at 42 . This methodology, as both E&Y
27
and NextCard knew, would understate NextCard's loan loss provision expense and overstate
28 I earnings for at least four reasons . First, E&Y knew that NextCard had loosened the underwriting
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-16-
1 criteria and approved loans to applicants with sub-prime FICO scores . Thus, the loss experience on
2 older, higher quality loans was not an accurate predictor for newer lower quality loans . Second,
3 E&Y knew that the charge-off ratio applied to the credit card portfolio to determine the loan loss
4 provisions was materially understated because NextCard improperly classified certain credit losses
5 as fraud losses and excluded those losses from the charge-off rate . Third, E&Y knew the charge-off
6 rate was understated because NextCard removed delinquent loans from its portfolio before they
7 became 180 days delinquent in order to reduce the charge-off ratio . Fourth, E&Y knew that the
8 charge-off rate was improperly reduced based on the purported implementation of unproven
9 collection policies .
1 . E&Y Knew NextCard's Methodology for Establishing Loan
Loss Allowances Caused the Company to Report Inflated
11 Earning s
10
12 45 . E&Y knew that NextCard's methodology for determining loan loss allowances 13 applying a rolling average percentage of historical credit loss write-offs to the current credit card
14 loan portfolio - caused the Company to report inflated earnings because of the increasing level of
15 subprime loans made by NextCard during the Class Period . That is, E&Y knew the loss experience
16 on older, higher quality loans understated the amount of loss allowances required for the Company's
17 newer and lower quality loans .
is 46 . According to confidential witnesses, the OCC and the Office of Inspector General
19 ("OIG"), NextCard dramatically increased loans to subprime borrowers by lowering required FICO
20 scores . Two former high ranking officials at NextCard (CW3, a former chief marketing officer, and
21 CW4, former head of public relations) confirmed that NextCard lowered required FICO scores in
22 March 2000 and was having problems with collections . CW1, NextCard's former vice president of
23 risk management, also stated that the Company's underwriting criteria loosened considerably from
24 September 2000 through the end of the Class Period, due to a conscious decision to be more
25 aggressive .
26 47 . CWS, a former NextCard manager informed plaintiffs that by May 2001 the
27 Company had 200,000 to 300,000 subprime accounts with FICO scores below 660 . The former
28 manager stated that that level of subprime accounts comprised a significant portion of the
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -17-
1
Company's receivables, constituting 20%-30% of the Company's active accounts (approximatel y
2 I one million accounts) . CW1 confirmed that the level of subprime accounts comprised 30% of activ e
3 I accounts and that the level doubled from September 2000 to September 2001 .
4
48 . CW2, the former NextCard file transmission specialist who was responsible fo r
5 I manually keying NextCard's customer account write-offs into the computer system, stated that th e
6 I number of accounts written off "exploded" from approximately 100 customers per month t o
7 I approximately 2,000 customers per month from February 2000 to July 2001 .
8
49 . The OCC discovered the significant level of subprime loans when it requested an d
9
received a listing of all the accounts with FICO scores below 660 in approximately May 2001 -
10
when it began the examination that led to the closure of the bank . According to the OIG, by July
11
2001, 72% of NextBank's on-balance sheet loans and 38% of managed loans were to subprime
12
borrowers with FICO scores below 660 . Ex . 1 at 14 . From September 1999 to December 2001 the
13
average FICO score for NextBank's managed portfolio fell from 704 to 655, and the average FICO
14
score for on balance sheet loans had fallen to 526 . Id. Despite the increase in subprime loans,
15
NextCard continued to apply a rolling average percentage of historical charge-offs to determine loan
16
loss allowances for its current loan portfolio .
17
50 . E&Y knew NextCard's methodology for establishing loan loss allowances . Th e
18
methodology was disclosed in the Company's SEC filings which were reviewed by E&Y and in
19
E&Y's workpapers for the fiscal year 2000 audit . Specifically, E&Y's workpapers included a [l]oan
20
"[floss [m]emo" that disclosed NextCard applied a roll rate percentage of historical charge-offs to
21
determine loan loss allowances. Ex . 3, ¶53 . In addition, the methodology was listed as a
22
"significant accounting policy" in the notes to NextCard's fiscal year 2000 audited financial
23
statements . See fiscal year 2000 Report on Form 10-K at 39 . From their audits and reviews of
24
NextCard, E&Y also knew that NextCard had increased loans to sub-prime borrowers by lowering
25
FICO scores . In fact, analysts reported that NextCard had lowered FICO scores to increase growth .
26
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
_18-
I
2. E&Y Knew NextCard Improperly Classified Credit Losses as
Fraud Losses to Understate the Charge-Off Rate
2
51 . E&Y also knew that NextCard understated its loan loss provision expense (an d
3,
overstated earnings) by improperly classifying credit losses as fraud losses and excluding those
4
losses from the charge-off rate . NextCard charged-off loans once they became 180 days delinquent
5
(or within 60 days of receiving notification that a borrower had filed for bankruptcy) and those
6
charge-offs were included in the historical charge-off rate used to establish loan loss allowances .
7
However, fraudulent loans were charged off to non-interest expense within 90 days of discovery and
8
were not included in the charge-off rate used to establish loan loss allowances . See fiscal year 2000
9
Report on Form 10-K at 42 . Former NextCard employees informed plaintiffs that Hashman and Cai
10
caused NextCard to understate charge-offs and loan loss allowances by improperly classifying credit
11
losses as fraud losses . According to CW 1, a former vice president of risk management, and CW5,
12
Hashman and Cai made the decision to classify certain loan losses as fraud losses . CW1 said that
13
NextCard classified loan losses as fraud losses in three circumstances : first payment defaults ;
14
challenged bankruptcies ; and "skips," i.e., customers that disappeared. This witness estimated that
15
65%-70% of the fraud losses were attributable to challenged bankruptcies and 30% were attributable
16
to first payment defaults . CW 1 stated that neither CW 1 nor the OCC agreed with this classification
17
and that Hashman and Cai participated in several meetings with the OCC . CW7 stated that a former
18
NextCard fraud manager stated that the Company's treatment of fraud losses was inappropriate and
19
not in line with industry standards . CW7 also stated that the former fraud manager left the Company
20
shortly after voicing his opinions to Cai .
21
52 . CWI stated that NextCard classified challenged bankruptcies as credit losses unti l
22
2QOI when Hashman and Cai decided to classify them as fraud losses . CW I stated that the practice
23
was not consistent with the rest of the industry and that CW I and the OCC disagreed with it . CW I
24
stated that the practice was improper and that anyone who says otherwise is lying . CW I also stated
25
that by removing delinquent loans classified as "challenged bankruptcies" from the pool of loans
26
used to calculate loan loss allowances, the Company's loan loss provisions and loan reserve s
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - - 19 -
1
declined significantly. It also reduced the level of reported delinquent loans because the Compan y
2 I wrote-off the loans (as opposed to establishing a reserve) classified as fraud losses .
3
53 . According to the O1G, the OCC also concluded that NextBank improperly classifie d
4
credit losses as fraud losses beginning in 1Q00 .
5
classifications did not conform to industry practice and were inconsistent with other aspects of
6
NextBank's operations . For example, NextBank classified certain loan losses as fraud losses even
7
though NextBank failed to file a Suspicious Activity Report on the loan. Banking regulations (12
8
C .F .R . §21 .11) required NextBank to file a Suspicious Activity Report with the Treasury Department
9
and the appropriate federal law enforcement agencies when they detected a known or suspected
10
violation of federal law . NextBank also classified certain loan losses as fraud losses despite the lack
11
of involvement by NextBank's Fraud Department . Finally, the OCC also noted that NextBank
12
classified losses as fraud losses even though NextBank charged off the loan after 180 days (which
13
NextBank publicly reported was its policy for charging off credit losses) instead of 90 days to be in
14
line with NextBank's fraud policy .
Ex, 1 at 19-21 . The OCC found that the
15
54. By improperly classifying credit losses as fraud losses, NextCard understated th e
16
charge-off rate applied to the existing credit card portfolio to determine loan loss provisions which
17
caused the Company to overstate earnings and the net interest margin (after loan loss provisions), a
18
key indicator of financial performance and credit quality . As shown below, the Company's net
19
interest margin was deteriorating . It was important for the Company to mitigate the deterioration
20
and to report a higher net interest margin to address the concerns analysts raised about the
21
Company's credit quality prior to and throughout the Class Period . The following table illustrates
22
how the Company's loan loss provisions and net interest margin were understated throughout the
23
Class Period .2
24
25
26
27
2 The figures for Net Interest Income, LLA Provision and Net Interest Income were contained
in the Company's SEC filing . The fraud loss provisions were derived from or reported in
NextBank's FFIEC Call Reports .
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -20-
1
03/00
06/00
09/00
12/00
2
Net Interest Income
$9,165
$9,721
$12,595
$12,741
3
LLA Provisio n
$8,600
$9,563
$16,134
$22,843
$565
$158
($3,359)
($10,102 )
$1,487*
$2,206*
$4,101*
$3,821 *
03/01
06/01
09/0 1
Net Int. Income
$6,910
$7,158
$11,292
LLA Provisio n
$20,049
$18,509
$55,534
Net Interest Margin
($13,139)
($11,351)
($44,242)
12
Fraud Loss
Provision
$2,370
$2,692
$1,49 6
13
* estimate
4 Net Interest Margin
5
Fraud Loss
Provisio n
6
7
8
9
10
11
14
55 . E&Y was aware of, and approved, at least one of the reclassifications . Ex . 3 at ¶11 .
15
According to a November 11, 2001 email written by Trauger, Trauger knew that (1) NextCard had
16
reclassified credit losses as fraud losses as far back as 2Q00, (2) reclassified first payment defaults
17
as fraud losses in 1Q01, and (3) the reclassifications were material . Ex . 3, ¶1 j27-30 . In addition,
18
minutes from NextCard's July 23, 2001 audit committee meeting state "`Mr. Trauger was
19
comfortable with the company's decision to categorize first payment defaults as fraud losses ."' Ex .
20 1 3,'30.
22
3. E&Y Knew NextCard, by Selling Del inquent Loans Just
Before They Had to Be Charged Off, Understated Its ChargeOff Rate
23
56 . NextCard also manipulated and understated its charge-off rate by selling delinquent
24
loans just before they had to be charged off, thereby lowering the charge-off rate . After the Class
25
Period, NextCard admitted in its 3Q01 Report on Form 10-Q that in addition to securitizing and
26
selling credit card loans, the Company also had a systematic program in place to sell certain
27
delinquent loans to third parties . See 3Q01 Report on Form 10-Q at 6 . Those delinquent loans were
28
classified as loans held for sale and any subsequent declines in value were accounted for as a
21
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -21-
1
noninterest expense, rather than being accounted for as a charge-off . That is, once the loans were
2
"held for sale" they were excluded from NextCard's charged-off loans . Thus, this impropriety had
3
the same effect as the improper reclassification of credit losses as fraud losses, i.e., losses incurred
4
on the delinquent loans held for sale portfolio were not included in the charge-off rate .
5
57 . E&Y knew that NextCard understated the charge-off rate by selling loans before they
6 became delinquent and had to be charged off . E&Y knew that NextCard was manipulating its
7
portfolio, falsely reporting its charge-off rate to the market, and that it was doing so to mislead the
8
market into believing its loan portfolio was more sound than it was . E&Y's 2000 audit workpapers
9
note that NextCard began this improper practice at least by December 2000 and that the reason
10
NextCard sold delinquent loans prior to the time of charge-off was to "`reduce its allowance for loan
11
losses"' and to "`decrease its loan loss allowance expense ."' Ex . 3, ¶53 .
12
workpapers included the following notation :
13
14
15
Specifically, E&Y
"In December 2000, NextCard began to apply a different accounting
treatment for its delinquent loans . As stated above, the Company began to charge off
loans once they became 90 days delinquent . However, in order to reduce its
allowance for loan losses, decrease its loan loss allowance expense, and clean its
portfolio for securitization purposes, the Company began to remove these accounts
from its portfolio. "
16
Ex. 3, x(53.
17 ''.
58 . As explained below, E&Y altered the workpaper after the OCC requested E&Y' s
18
workpapers and produced an altered workpaper that stated "In December 2000, NextCard began to
19
sell delinquent loans prior to the time of charge-off." E&Y deleted the notations that showed the
20
accounting practice had been changed and that the reasons for the change were to improperly reduce
21
loan loss allowances and the loan loss allowance expense .
22
23
24
4 . E&Y Knew NextCard Improperly Reduced the Charge-Off
Rate Based on a New and Unproven Collection Polic y
59 . E&Y kn ew that in the notes to the Company ' s fiscal year 2000 audited financia l
25 I statements, it was represented that NextCard considered "collection trends" in evaluating th e
26
adequacy of loan loss allowances. Fiscal year 2000 Report on Form 10-K at 39 . In addition, E&Y
27 I knew NextCard's loan loss allowances were understated (and earnings overstated) because NextCar d
28
had improperly reduced the charge -off rate based on NextCard ' s purported implementation of
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -22-
"rigorous collection policies." Ex . 3 at 53 . E&Y's fiscal year 2000 audit workpapers stated that
NextCard had reduced the roll rate percentages (i .e ., historical charge-off rate) based on its
implementation of rigorous collection policies . Ex. 3, 153 . However, E&Y also noted that the
impact of the purported collection policies needed to be checked during the 1Q0I review to ensure
the policies were effective and to assess if NextBank's loan loss reserve analysis requires further
adjustment . Id. Specifically, E&Y's fiscal year 2000 audit workpapers included the following
notations :
8
9
10
11
12
"We have discussed with the client the fact that given the nature of the economy,
there will need to be close monitoring in the 1' quarter 2001 to ensure that the
reserve amounts are reasonable given shifts in the economy . Furthermore, since the
client has reduced its roll rate percentages based on its implementation of rigorous
collection policies, the impact of these policies will need to be checked at first
quarter 2001 to ensure that these policies are effective and to assess if the client's
loan loss reserve analysis requires further adjustments . "
Ex. 3, X53.
13
60 . As the workpaper notation shows, E&Y knew that the '"rigorous collection policies" '
14
were unproven and did not provide any basis for reducing the charge-off rate and the Company' s
15 I loan loss allowances . Indeed, E&Y deleted the entire workpaper notation to conceal its knowledg e
16 I of the impropriety from the OCC . Ex . 3, ¶53 .
17
61 . In addition, E&Y's IQ01 workpapers indicate that E&Y knew the collection policy
18
did not warrant a reduction in the charge-off rate. E&Y's 1 Q01 workpapers disclosed that
19
Next Card's assumptions for its loan recovery rate were "aggressive" and that the Company's loan
20
loss reserves remained at the low end of the acceptable range for its reserves . Ex . 3, ¶62 . To
21
conceal its knowledge, E&Y deleted the workpaper notation that stated that NextCard's loan loss
22
reserves remained at the low end of the acceptable range and altered the workpaper that stated that
23
NextCard's assumptions for its loan recovery rate were "aggressive" by deleting the term
24
"aggressive" and replacing it with the word "conservative ." Id. E&Y then produced the altered
25
workpapers to the OCC .
26
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
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-23-
5. E&Y's Knowledge of the Accounting Improprieties Related to
Loan Loss Allowances Is Shown by Their Alteration,
Destruction and Falsification of Their Audit and Review
Workpaper s
1
2
3
62 . As explained above, E&Y altered their audit and review workpapers to conceal their
4
knowledge that NextCard was reporting inflated earnings in violation of GAAP by not establishing
5
. The alterations and deletions are summarized below
Ysuficentloa ws
.
6
(a) E&Y deleted the delinquency and charge-off percentages included in thei r
7
audit workpapers and altered other delinquency and charge-off percentages to match the fals e
8
percentages reported by NextCard in their audited 2000 financial statements . Ex . 3 . ¶53 .
9
(b) E&Y concealed its knowledge that NextCard had improperly reclassified
10
credit losses as fraud losses and that the reclassifications were material . Ex . 3, ¶x(27-30 .
11
(c) E&Y deleted the references in their workpapers that showed NextCard was
12
selling delinquent loans before they had to be charged off to "`reduce its allowance for loan losses,
13
decrease its loan loss allowance expense, and clean its portfolio for securitization purposes ."' Ex . 3,
14
1 X53 .
15
(d) E&Y deleted the references in its audit workpapers that showed NextCard
16 ''.
reduced the charge-off rate due to the implementation of an unproven collection policy . Ex . 3,'53 .
17
(e) E&Y falsified its 1Q01 workpapers by changing how E&Y characterize d
18
NextCard's assumptions for its loan recovery rate . E&Y initially characterized NextCard's
19
assumptions as "` [a]ggressive,"' but after the OCC requested E&Y's workpapers, E&Y changed its
20
workpapers to state that NextCard's assumptions were "`[c] onservative ."' Ex . 3,'62 .
21
(f) In addition to those workpaper alterations, E&Y also deleted a 1Q0 1
22
workpaper that stated NextCard "`remains at the low end of the acceptable range for its reserves ."'
23
Ex . 3,'62 .
24
(g) E&Y also significantly revised the'"Allowances for Loan Losses"' section of
25
the 2Q01 summary review memorandum . Ex . 3,163.
26
(h) The destruction and alteration of the workpapers occurred after E&Y learned
27
that the OCC was challenging NextCard's loan loss allowances and E&Y's audit procedures, after a n
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -24-
1 E&Y partner suggested that E&Y begin '"retrospective review procedures"' to determine whether
2 NextCard's loan loss allowances had been recorded in the correct reporting periods and after
3 shareholder suits were filed against NextCard that alleged the Company had purposely
4 mischaracterized its true loan loss levels . Ex . 3, ¶1115-16, 26-27 .
5
6. E&Y's Knowledge of the Accounting Improprieties Related to
Loan Loss Allowances Is Also Shown by the Magnitude of the
6 Additional Loan Loss Allowances Established by NextCar d
After the Class Period
7
63 . The magnitude of the increase in loan loss allowances after the Class Period confirms
8
that the loan losses were materially understated during the Class Period and that E&Y knew it . The
9
Company incurred a $55.5 million expense in 3Q01 and increased loan loss allowances from $31 .1
10
million as of June 30, 2001 to $71 .6 million as of September 30, 2001 . The OCC required NextBank
11
to (1) increase loan loss allowances by $13 .2 million, (2) establish a $5 .6 million reserve for
12
uncollectible interest and fees and (3) reclassify $12 million of fraud losses and credit losses . Ex . 1 at
13
19-20 .
14
64. E&Y's knowledge is also established from information provided by the witnesses .
15
CW3 and CW4 confirmed that the OCC believed there were credit problems at NextCard as early as
16
October 2000 when the OCC insisted upon a capital assurance agreement that required NextCard to
17
maintain NextBank's capital at 12% of risk weighted assets, 50% more than required by federal
18
banking regulations . The capital assurance agreement was dated October 26, 2000 and was insisted
19
:upon by the OCC following its examination of NextBank in 2000 . Both individuals also stated that
20
they had discussions with several NextCard employees in late 2000 who expressed concern about the
21
bank's loan loss allowances . For example, Scott Lascelless, NextCard's former vice president of
22
customer management told the former chief marketing officer that NextCard's credit quality and
23
charge-offs were "getting out of hand" and that things were going to "blow up ." Chris Hamilton,
24
vice president of credit, told the former head of public relations that in late 2000 he had concerns
25
about the Company's loan loss allowances and charge-offs .
26
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
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-25-
1
65 . The failure to establish adequate loan loss allowances violated GAAP (SFAS 5 and
2
114), SEC regulations (17 C.F.R. §210.4-01(a)(1)) and federal banking regulations (12 C .F.R. Part
3 13).
7. E&Y Knew NextBank Reported Inflated Earnings and Capital
by Improperly Capitalizing Credit Card Acquisition Cost s
4
5
66. NextCard spent money on advertising to attract credit card customers and recorded
6
the cost as sales and marketing expenses as required by GAAP . NextBank actually made the credit
7
card loans after NextCard acquired a customer and sold the account to NextBank for the cost of th e
8
acquisition . Although NextCard expensed the loan acquisition costs, NextBank improperly
9
capitalized them . The improper capitalization caused NextBank to overstate earnings and capital by
10
$35 .7 million .
11
67. The OCC discovered that NextBank was improperly capitalizing the loan acquisition
12
costs during its 2001 examination. Ex . 1 at 19 . E&Y knew that GAAP required NextBank to
13
expense the deferred loan acquisition costs . According to SFAS 91, loan acquisition costs may be
14
capitalized only if paid to an independent third party . SFAS 91, T6-7 . Because NextCard was not
15
an independent third party, SFAS 91 required NextBank to expense the deferred loan acquisitio n
16
costs paid to NextCard .
17
68 . E&Y's work-papers show that they knew of this accounting impropriety . Specifically ,
18
E&Y's 3Q00 review workpapers included numerous references stating that FAS 91 required
19
NextBank to reverse deferred loan acquisition costs that had been previously capitalized . Ex. 3, x ;56.
20
When the OCC requested E&Y's workpapers, every one of the references was deleted from the
21
3Q00 review workpapers before they were produced to the OCC . Id.
22
69 . E&Y's fiscal year 2000 audit workpapers also included notations showing that they
23
did not require NextBank to reverse the capitalized acquisition costs even though E&Y knew GAAP
24
required the deferred loan acquisition costs to be expensed . Moreover, E&Y's workpapers included
25
notations stating that NextBank's practice "`is not consistent with the majority of its industry
26
peers ."' Ex . 3, ¶55 . E&Y deleted the notations stating thatNextBank's practice of capitalizing loan
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-26-
1
acquisition costs was inconsistent with the majority of its peer group before they were produced t o
2
the OCC . Id.
3
70. NextBank's write-off of the capitalized loan acquisition costs after the Class Perio d
4 I confirms the impropriety. On October 31, 2001, NextBank announced that it had expensed $35 .7
5 I million of improperly capitalized loan acquisition costs.
6
71 . The material amounts of loan acquisition costs that were improperly capitalize d
7 I violated GAAP (SFAS 91), SEC and banking regulations and the Company's financial policies .
8
Specifically, NextBank overstated earnings, capital and regulatory capital by improperly capitalizin g
9
the card acquisition costs .
10
72. E&Y knew that NextCard reported its regulatory capital and its regulatory capital
11
requirement in its fiscal year 2000 audited financial statements and its quarterly financial statements
12
that were reviewed by E&Y . For example, NextCard reported that NextBank's total risk based
13
capital was $187 million as of December 31, 2000 . E&Y knew that representation was false because
14
NextBank had overstated earnings and capital by improperly capitalizing loan acquisition costs .
15
73. As the write-off of the capitalized acquisition costs confirms , there was no reasonabl e
16 basis for NextBank to capitalize the card acquisition costs that NextCard expensed . The sole
17 motivation for the improper capitalization was to inflate NextBank's earnings and capital and avoid
18
paying NextBank additional funds required to maintain its risk-based capital at levels required by the
19
undisclosed October 26, 2000 capital assurance agreement . Deutsche Bane Alex . Brown Inc . analyst
20
R. Zandi recognized the scam . In a report issued on November 1, 2001 he summed it up as follows :
21
Every time that we have meet with management or have seen them present to
investors, they went to great pains to insist that the company was operated on a
conservative basis . High credit quality and conservative accounting . After all, so
they argued, NextCard was regulated so their accounting had to be conservative .
There is no scenario we can imagine in which capitalizing acquisition costs at
NextBank can be viewed as conservative accounting. Very damning in our
opinion .
22
23
24
25
26
8 . E&Y Knew NextCard Reported Inflated Earnings By Failing
to Write Down the Se l ler's Interest From Securitization s
74 . According to the OIG Report, the terms ofNextBank's securitization trust agreement s
27
required NextBank to retain a seller's interest in the trust. Ex . 1 at 18-19 . NextBank improperl y
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-27-
1 accounted for its retained interest as a receivable and reported the retained interest at par . Id.
2 However, because the seller's interest was "certificated," NextBank should have recorded the
3 seller's interest as a security . Id. GAAP (SFAS 115) required NextBank to report a security at its
4 current fair market value . SFAS 115 . Because the fair market value of the retained interest was less
5 than par, the OCC required NextBank to write down the retained interest by $22 million . Ex . 1 at
6 18-20 .
7 75 . E&Y audited NextCard's securitization activities and knew that NextCard represented
8 in the notes to its fiscal year 2000 audited financial statements that the retained interests were
9 reported at estimated fair value . Based on the findings of the OCC, E&Y knew or was deliberately
10 reckless in not knowing, that NextCard did not properly account for its retained interests .
11 C. E&Y Knew NextCard Reported Inflated Regulatory Capital Ratios
by Improperly Excluding Sold Loans from R isk Weighted Assets
12
76. - Banking Regulations, 12 C .F .R. §6 .4, states that a bank is (1) "well capitalized" if the
13
risk based capital ratio is 10% or greater, (2) "adequately capitalized" if the risk based capital ratio is
14
8% or greater, (3) "undercapitalized" if the risk based capital ratio is less than 8%, and (4)
15
"significantly undercapitalized" if the risk based capital ratio is less than 6% . If a bank was
16
undercapitalized or significantly undercapitalized it was subject to various mandatory "prompt
17
corrected action" restrictions (including restrictions on growth) and had to file a capital restoration
18
plan with the OCC . 12 C .F.R. Part 6 .
19
77 . In every Report on Form 10-Q and Form 10-K that E&Y audited or reviewed before
20
they were filed with the SEC, NextCard reported its regulatory capital ratios and represented that it
21
was "well capitalized" because its total risk based capital ratio was above 10% of risk weighted
22
assets.
23
03/31/00 06/30/00 09/30/00 12/31/00
24
Risk-based Capital Ratio 11 .8% 12 .2% 11 .37% 15 .73%
25
26
03/31/01 06/30/01
27 Risk-based Capital Ratio 12 .6% 17 .35%
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -28-
1 78 . NextBank materially understated its risk-based capital requirement by failing to
2 include sold loans in risk weighted assets . NextCard falsely represented in its SEC filings that
3 investors in the Company's securitization transactions had "no recourse" against the Company for
4 any customers' failure to pay their credit card loans . See, e.g., Note 8 to NextCard's audited fiscal
5 year 2000 financial statements contained in the Company's SEC Report on Form 10-K . Under
6 federal banking regulations (12 C .F.R . Part 3), only loans sold without recourse could be excluded
7 from NextBank's risk weighted assets . Per the undisclosed capital assurance agreement, the OCC
8 required NextCard to maintain NextBank's risk-based capital at 12% of risk weighted assets . As
9 shown in the following table, NextBank's risk-based capital requirement would have increased
10 substantially if sold loans were included in risk weighted assets (in millions) .
11
03/31/00 06/30/00 09/30/00 12/31/00
12 Securitized Loans No t
Included in RWA $300 $300 $520 $762 .5
13
Corresponding Reductio n
14 In Risk-Based Capital $36 $36 $62 .4 $91 .5
15
03/31/01
06/30/01 06/30/0 1
16 Securitized Loans No t
Included in RWA $1,115 $1,200 $1,264
17
Corresponding Reduction
18 In Risk-Based Capital $133 .8 $144 $151 .7
19 79 . In fact, contrary to the representation in the Company's SEC filings, purchasers did
20 have recourse against NextCard for its customers' failure to pay . As explained in a February 7, 2002
21 OCC press release and the OIG Report, during its 2001 examination of NextBank, NextBank was
22 repurchasing delinquent loans sold into a securitization trust that it classified as fraud losses even
23 though the delinquencies were attributable to credit quality problems . Ex . 1 at 21 . The OCC and
24 CW 1 stated that the Company's classification of certain loan losses (which were credit loss) as fraud
25 losses was improper and inconsistent with industry standards . According to the OCC, that practice
26 constituted a sale of assets with recourse that required all the sold loans to be included in risk
27 weighted assets . On October 11, 2001, the Company disputed and appealed the OCC's findings .
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-29-
1 That appeal was rejected by the OCC on October 29, 2001 . A copy of the October 29, 2001 letter is
2 attached as Ex . 6 and incorporated by reference .
3 80 . When the loans were properly included in risk weighted assets, total risk weighted
4 assets increased by more than $1 billion from S 1 .08 billion as of June 30, 2001 to $2 .1 billion as of
5 September 30, 2001 . That increase alone caused NextBank's risk-based capital requirement to rise
6 by more than $120 million and NextBank's risk based capital ratio to decline from 17 .35% as of
7 June 30, 2001 to 5 .38% as of September 30, 2001 . A February 12, 2002 New York Times article
8 reported that the impropriety was reminiscent of the problems at Enron .
9 81 . E&Y knew about this impropriety . E&Y contends on its website that it has tackled
10 critical areas such as regulatory capital requirements . E&Y also reviewed and audited this part of
11 NextCard's business . In fact, E&Y knew NextCard had reclassified credit losses and fraud losses
12 and E&Y's knowledge is established by the inclusion of various notes in NextCard's audited
13 financial statements regarding the Company's securitization business and its regulatory capital
14 requirements . Further, E&Y knew that NextCard reported its regulatory capital ratios and
15 represented that it was "well capitalized" in every Report on Form 10-Q and Form 10-K filed with
16 the SEC during the Class Period . In fact, E&Y certified NextCard's fiscal year 2000 financial
17 statements included in the Report on Form 10-K and reviewed and approved the Report on Form 1018 Qs before they were filed with the SEC . In addition, E&Y's 3Q00 review workpapers included a
19 "Securitization Memo" and the summary review memorandum from the fiscal year 2000 audit also
20 included references to the Company's securitization activities . Ex . 3, 55-57 .
21 VII. E&Y TRIES TO COVER UP ITS PARTICIPATION IN THE FRAUD
22 A. E&Y Provided Altered and Falsified Workpaper to the OCC to
Conceal Its Knowledge that NextCard's Publicly Issued Financia l
23 Statements Were Materially False and Misleadin g
24 82 . The OCC began the 2001 examination of NextBank in May 2001 and quickly
25 identified numerous problems . The OCC transferred supervision to its Washington D .C .
26 Headquarters Special Supervision and Fraud Division and expanded the examination team with
27 specialized examiners . Ex . 1 at 25-26 . Trauger, the E&Y partner responsible for NextCard, was
28 aware of the OCC's comprehensive examination . Ex . 3, N12 .
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
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-30-
83, In approximately October 2001, Trauger told several members of the NextCar d
1
2
engagement team that the OCC had challenged the sufficiency ofNextCard's loan loss allowances as
3
well as E&Y's audit procedures for NextCard . Ex . 3, 15 . Also in October 2001, Trauger told
4
Flanagan that the OCC had requested certain E&Y workpapers from the fiscal year 2000 audit and
5
the review of NextCard's 1 Q01 and 2Q01 financial results . Id. at 16. Flanagan gathered the
6
requested documents and gave them to Trauger for his review before they were produced to the
7
OCC . Id. According to Flanagan, Trauger with the assistance of Flanagan and others altered E&Y's
8
workpapers generated during the 2000 audit and the 1Q0I and 2Q01 reviews . Ex. 2 at 3-4 .
9
84 . For example, in Flanagan's presence and while reviewing a spreadsheet included i n
10
E&Y's 2000 audit workpapers concerning NextCard's securitization of loans, Trauger altered the
I1
spreadsheet by adding a handwritten note of explanation to the top of the spreadsheet . Ex . 3, 16.
12
According to Flanagan, the text ofTrauger's note came from a separate memorandum that had been
13
included in E&Y's 1999 working papers . Id. To conceal the alteration, Trauger initialed but did not
14
date his handwritten notation . Id. Further, Trauger instructed Flanagan to photocopy his handwritten
15
notation and to cut and paste the text on all subsequent versions of the spreadsheet that appeared in
16
E&Y's workpapers in subsequent periods . Id. at ¶17 . After Flanagan made these changes, on
17
approximately October 22, 2001, Trauger and Flanagan personally delivered various documents to
18
the OCC, including the altered documents . Id.
85 . After NextCard issued its October 31, 2001 press release, nine lawsuits were file d
19
20 I against NextCard and various officers and directors between November 1, 2001 and December 4 ,
21 12001 . None of the lawsuits named E&Y as a defendant .
22
86 . On November 2, 2001, another E&Y partner who was not a member of the NextCard
23
engagement team sent an email to Trauger after being consulted on the engagement that suggested,
24
among other things, that E&Y begin "`retrospective review procedures"' to determine whether
25
NextCard's loan loss allowances had been recorded in the correct reporting periods in 2001 . Ex. 3,
26
¶26 .
27
87 . On November 11, 2001, Trauger sent an email to NextCard's CEO (Hashman), CF O
28
(Rigione) and controller that included various comments that were "'meant to mitigate risk given the
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -31 -
1
events which have occurred since the [October 31, 20011 press release went out"' and which
21' indicated Trauger had reviewed the allegations contained in the lawsuits filed against Next Card as a
3
result of the October 31, 2001 press release . Ex . 3, ¶27 . In fact, Trauger stated in the email that
4
"`from our perspective, the most troubling allegations in the shareholder suits relate to comments
5
like "the Company .. . purposely mischaracterized its true loan loss levels .""' Id. Trauger also noted
6
that he had spent "a fair amount of time" with NextCard's controller discussing the issue of whether
7
or not the change in the definition of fraud losses required by the OCC would require a restatement
8
of NextCard's financial statements from prior reporting or whether the change could be handled
9 prospectively, without a restatement . Id. Trauger also noted that he was aware of the change made
10
in 1Q01 of reclassifying non-payment defaults as fraud losses, and the minutes of NextCard's July
11
31, 2001 audit committee meeting note "`Mr . Trauger was comfortable with the company's decision
12
to categorize first payment defaults as fraud losses ."' Id., ¶J28, 30 .
13
88 . On November 11, 2001, Trauger also sent an email to Flanagan asking him to collec t
14
all of E&Y's workpapers from the 2000 audit and from the 1Q01 and 2Q01 quarterly reviews
15
relating to NextCard's allowance for loan losses and fraud losses . Ex . 3, ¶29 . Trauger wrote that
16 NextCard had been "`broadening its definition of fraud for some time (back to Q2 2000) and the
In fact, E&Y had been aware of these changes as they occurred . Id.
17
changes are material ."' Id.
18
Flanagan forwarded the email to the audit manager, Mullen, the next day and asked him to collect
19
the documents that Trauger requested . Id.
20
89 . According to Flanagan, in November 2001, while the OCC examination was stil l
21
ongoing, Trauger told Flanagan that he wanted to review E&Y's work on NextCard's 2000 audit in
22
order to '"beef up"' what was in the working papers to make it appear that E&Y was "`right on the
23
mark"' all along . Id., T31 . Trauger also told Flanagan that he wanted to go back and make sure that
24
everything in the NextCard files would not be second guessed by "`some smart-ass lawyer"' in the
25
event the files were ever subpoenaed . Id. Trauger asked Flanagan to come in on a Saturday in
26
November 2001 to help him review NextCard's workpapers and also instructed Flanagan to research
27
the issue of how AWS files could be modified after the files had been archived in E&Y's AW S
28
database . Id.
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-32-
1
90 . On November 2, 2001, Mullen sent an email to Flanagan forwarding research done by
2
an E&Y staff accountant that informed Trauger and Flanagan that (1) the copy of archived
3
workpapers maintained on E&Y' s nationwide server could not be modified and (2) it was E&Y's
4
policy that additional documentation obtained after the archive of AWS files "`should be done in
5
hard copy and filed in a separate section of the hard copy working paper file."' Ex. 3, '32 .
6
However, the forwarded email also disclosed that "`in rare circumstances and with the approval of
7
the engagement partner,"' changes may be made to AWS files maintained on a local server and then
8
re-archived, deleting the previously archived AWS files . Id.,' 33 . The forwarded email also stated
9
that "`in cases of re-archiving, no record will be maintained of the original archive file ."' Id. In his
10
email to Flanagan and Trauger, Mullen commented on the attached research by writing, "`I am not
11
sure what we want to do . The 2000 workpapers are essentially frozen. I think we should discuss in
12
person."' Id.
13
91 . Trauger and Flanagan met at E&Y's San Francisco, California, offices on a Saturday
14
in November 2001 to alter working papers from the NextCard audit engagement . Ex . 3, ¶34 .
15
Flanagan used his laptop computer to access and review all the AWS files stored on E&Y's local
16
server related to E&Y's 2000 audit . Id. At Trauger's direction, Flanagan made changes to working
17
papers regarding NextCard's loan loss allowances and its securitization of receivables . Id. Trauger
18
also directed Flanagan to alter the date on his laptop computer so it would appear the changes to
19
various documents had been made at the time of E&Y's original work on the audit . Id., 35.
20
92. After Trauger and Flanagan altered various workpapers during the Saturday meeting
21
at E&Y's San Francisco, California, office, Trauger told Flanagan he wanted to review additional
22
NextCard files from E&Y's 2000 audit as well as working papers related to the quarterly reviews
23
performed for NextCard in 2001 . Id. Trauger told Flanagan to request Mullen's assistance to collect
24
the requested files and working papers . Id.
25
93 . During the evening of November 20, 2001, at E&Y's San Francisco offices ,
26
Flanagan, Trauger and Mullen used Mullen's computer to access and alter AWS working paper s
27
from the 2000 audit and the 2001 quarterly reviews on the local server . Id., ¶36 . Flanagan explaine d
28
to Mullen how to change the clock on his computer to make it appear as though the alterations were
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -33-
1
made at the time the document was originally created . Id. During the meeting Trauger reviewed the
2
AWS files and wrote down the changes he wanted made to various documents and Mullen then
3
typed the changes Trauger wanted . Id. According to Flanagan the altered workpapers concerned
4
NextCard's loan loss allowances and NextCard's securitization of receivables . Id.
5
94 . On Wednesday, November 21, 2001, Mullen sent an e-mail to Flanagan attaching
6
copies of a "Summary Review Memorandum" and a memorandum analyzing NextCard's loan loss
7
allowances ("2000 loan loss memo") that were originally created as part of E&Y's 2000 audit of
8
NextCard . Id., ¶37 . In the email, Mullen wrote, "Here are the memos we discussed, sorry I could
9
not email them to you last night . .. . Let me know when you would like to sit down and discuss if
10
there are other items, I would like to delete the AWS for NXCD 2000 on my hard drive . Also there
11
is a back up disk in the 2000 workpapers we should remove ." Id . A chart attached to the Richards
12
Affidavit and reproduced below details the alterations and deletions made to the 2000 loan loss
13
memo . The reproduced chart shows that E&Y altered its workpapers to conceal their knowledge
14 ''. that NextCard had understated delinquencies and charge-offs and improperly reduced its loan los s
15
allowances .
16
1 2001 Version. .
17
18
19
20
21
22
23
24
25
26
27
28
"`In December 2000, NextCard began to
apply a different accounting treatment for
its delinquent loans . As stated above, the
Version P
d
"'In December 2000, NextCard began to sel l
delinquent loans prior to the time of charge off." '
Company began to charge off loans once
they became more than 90 days delinquent .
However, in order to reduce its allowance
for loan losses, decrease its loan loss
allowance expense, and clean its portfoli o
for securitization purposes, the Company
began to remove these accounts from it s
portfolio ."'
"`Reserves as a percentage of loans"' for
NextCard at 12/31/00 : 4.61%
"`Delinquencies as a percentage of loans"'
for NextCard at 12/31/00 : 4.23%
"`Charge-off rate"' for NextCard at
12/31/00: 4.99%
"Cross reference in a chart comparing
NextCard with Industry Ratios : `NextCard
'"Reserves as a percentage of loans"' fo r
NextCard at 12/31/00: 4.76%
"`Delinquencies as a percentage of loans"' fo r
NextCard at 12/31/00 : 3 .92%
"`Charge-off rate"' for NextCard at 12131100 :
3.10%
"Deleted "
ratios for 9/30/00 have been calculated a t
E.5 . NextCard ratios for 12/31/00 hav e
been calculated at E7 .6
."'
"'Percentage of accounts 60 days and
" Deleted "
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -34-
1
2
3
4
5
greater' for NextCard :
December 31, 1999 : 1.36%
September 30, 2000 : 3 .13%
"`Net charge-offs as a percentage of "Deleted"
average loans ( on-balance sheet)' for
NextCard :
December 31, 1999: 0.16%
September 30, 2000 : 1.93 %
t
6
. H1 nnnn .
n A'1n/? l
"`Net charge-off as a percentage of average
loans (off-balance sheet)' for NextCard at
"`Net charge-off as a percentage of average
loans (off-balance sheet)' for NextCard at
'" We have noted that the Company's
average receivable life is approximately 8
mon ths. However, the lagged coverage
periods as of year-end 2000 are less than
the expected life of the receivables . Per
discussion with the client, the short
coverage periods are conservative given the
fact that the client expects to securitize
most of its loans in 2001 ."'
"`We have noted that the Company's average
receivable life is approximately seven months .
As such, the lagged coverage periods as of
year-end 2000 are equal to the expected life of
the receivables. In addition, the Company has
told us they plan to securitize approximately
$300 million receivables in the first quarter of
2001 (i .e., no allowance would be needed to
cover months after March 2001) . The
Company also expects that their new
collections process will increase their numbe r
"`We have discussed with the client the fact
that given the nature of the economy, there
will need to be close monitoring in the 1st
quarter 2001 to ensure that the reserve
amounts are reasonable given shifts in the
economy . Furthermore, since the client has
reduced its roll rate percentages based on
its implementation of rigorous collection
policies, the impact of these policies will
need to be checked at first quarter 2001 to
ensure that these policies are effective and
to assess if the client's loan loss reserv e
"Deleted ."
7
9
10
11
12
r, ------L- 9I nnnn_ ) 1 rwl »
13
14
15
16
17
18
19
20
21
22
Ex. 3, 153.
95 . E&Y also altered and deleted references in their 1Q01 review workpapers tha t
showed they knew NextCard was not establishing sufficient loan loss allowances .
23
24
25
Octoberr 25, 2001 Version
"In the `Allowance for Loan Losses'
Version Produced to OCC/SE C
"In the same table, the recovery rate i s
portion of the SRM, a table contains the
characterized as : "
following characterization of th e
26
Company's assumptions for its loan
recovery rate :"
27
"`A ressive
28
"`Conservative
"`Per review of the different scenarios
being used for the reserve analysis, we
"Deleted"
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-353S -
have noted that the Company remains at
the low end of the acceptable range for its
reserves ."'
"`There were several off-balance sheet "There were several off balance sheet
securitizations that took place in the 1 securitizations that took place in the 1st quarter
as indicated above . The gain on the
quarter as indicated above . Many of the
client's assumptions changed in booking
sale/interest only strip of the valuation
the gain on these securitizations . The [sic] assumptions used by the Company were as
include the following :"' follows:"
"[A column in table was deleted which
reflected certain assumptions regarding
xr---`/'+----_7)
7
`_ _----r .t_ .1___
- 7']/9 7 //)fl 1 '
Ex. 3, 62 .
9
96. E&Y also deleted all references in the workpapers showing their knowledge that
10
NextCard had improperly capitalized deferred loan acquisition costs in violation of GAAP . The
I1
following chart summarizes the deletions made to the 3Q00 summary review memorandum relate d
12
to deferred loan acquisition costs.
13
July 2000 Version
Version Produced to O C S E
14
15
16
"Under heading listing securitization issues
to be addressed during year-end audit for
2000:"
18
"`Reversal of deferred acquisition costs pe r
FAS 91 for receivables in the trust that hav e
been sold through securitizations ." '
"Under heading listing securitization issues
19
to be addressed during year-end audit for
2000 : "
17
20
21
22
23
24
25
"Deleted"
"Deleted "
"`Reversal of capitalized transaction cost s
for facilities that are taken off the balanc e
sheet in relation to securitized loans ."'
"One paragraph section with heading
`Reversal of Deferred Acquisition Costs ."'
"Two paragraph sections with heading
`Reversal of Capitalized Transactio n
Costs ."'
"Deleted "
"Deleted "
Ex. 3, ¶56 .
26
97 . The following chart reproduced from the Richards Affidavit summarizes the
27
alterations and deletions made to the fiscal year 2000 Summary Review Memorandum related to
28
deferred loan acquisition costs .
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -36-
2
3
4
5
6
7
8
9
July 2001 Version
Version Produced to D-CCISE C
"`There is diversity in practice in the industry
"`Industry practice with respect to DAC
with respect to the treatment of DAC upo n
[deferred acquisition costs] upon sale is
securitization of balances with some
mixed . However, most companies offset
companies offsetting these amounts against th e
these amounts against the gain on sale. As
gain on sale . The Company like most of it s
of December 31, 2000, no amounts were
peers continues to account for DA C
backed out of deferred acquisition costs for
.
We
performed
an
analysis
subsequent to securitization as only custome r
securitized loans
balances vs . the relationship is sold in a
of the impact of these potential adjustments
securitization . This is supported by EITF 92- 5
and noted that the amounts were immaterial
to the financial statements . However, going and FAS 91 ."'
forward the client will reverse these amount s
as it securitizes its portfolio ."'
"Deleted"
"`Consistent practice among most other
companies in the credit card industry is t o
remove all capitalized debt issuance cost s
related to off balance sheet securitizations ,
upon recognition of the gain on sale . (Bank
10
11
12
One does not follow this practice .)"'
"'NextCard has retained all capitalized debt
"[The first block of text remains unaltered] "
issuance costs for its securitizations on it s
balance sheet . Some contend that since the
receivables and the corresponding debt
"[The second block of text is deleted and th e
following text is substituted in its place :]"
facility for the receivables are sold an d
13
14
transferred off-balance sheet, the related
capitalization of prepaid debt issuance costs
should also be taken off the balance sheet
and included as part of the transaction cost
GAAP, however, provides that these cost s
should be capitalized on a theoretical basis as
the Company will still obtain benefits from th e
securitized portfolio in terms of recognizin g
15
of the securitization ."'
replenishment gains throughout the life of th e
16
"`Others however, contend that on a
the facility are still associated with ongoing
theoretical basis the Company will still
benefits to the client . We concur with the
obtain benefits from the securitized portfolio
in terms of recognizing replenishment gains
throughout the life of the securitization, and
client's position that the capitalized deb t
issuance costs have ongoing benefits and ar e
properly stated at 12/31/00 .
securitization, and therefore that the costs of
17
18
20
therefore that the costs of the facility are stil l
associated with the ongoing benefits to th e
client . We have accepted the client' s
position that the capitalized debt issuanc e
21
properly stated at 12131/00 . We have
19
22
costs have ongoing benefits and these ar e
indicated to the client that their practice i s
not consistent with the majority of it s
industry eers . " '
23
24
25
26
27
Ex. 3, t55 .
98. In November 2001, Trauger also directed Flanagan to meet with the audit manager
for the 2000 audit who had left E&Y in April 2001 . Id., ¶38 . Flanagan met with the former E&Y
auditor outside E&Y's offices and had her copy handwritten notes that she had originally written on
the securitization workpapers into a new version of the same document that had been altered b y
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-37-
1 Trauger . Id. Flanagan told the former E&Y auditor that the actions were appropriate because the
2 working paper was simply being "`recreated ."' Id.
3 99 . In short, as part of their fraudulent scheme, in November 2001, Trauger, Flanagan and
4 Mullen took numerous actions to cover up and conceal their knowledge that NextCard had reported
5 materially false and misleading financial results during the Class Period .
6 B. E&Y Withheld Information and Destroyed Information Subpoenaed
by the OCC to Conceal the Prior Workpaper Alteration s
7
100 . On November 15, 2001, the OCC issued a prompt corrective action directive
8
requiring NextBank, inter alia, to file an acceptable capital restoration plan and to limit new credit
9
card loans to applicants with FICO scores above 680 . On December 31, 2001, the Company
10
submitted a capital restoration plan that conceded the Company would have to pursue a liquidation if
11
it was unable to find a buyer . (On October 31, 2001 the Company issued a press release disclosing
12
that NextCard had retained Goldman Sachs to pursue a sale of the Company .) On January 12, 2002,
13
the Company notified the OCC that it was not possible to prepare and submit a capital restoration
14
plan and instead submitted an asset disposition plan detailing the Company's plan to liquidate the
15
assets and liabilities of NextBank . That plan disclosed that the liquidation would not raise enough
16
money to retire in full the bank's existing and anticipated liabilities .
17
101, On February 7, 2002, the OCC closed NextBank and appointed the FDIC as receiver
18
after finding that the bank was operating in an unsafe and unsound manner and had experienced a
19
substantial dissipation of assets and earnings through unsafe and unsound practices . Ex. 7 . The
20
OCC also determined that the unsafe and unsound practices were likely to deplete all of the bank's
21
capital and that there was no reasonable prospect for the bank to become adequately capitalized
22
without federal assistance . Id. Four days later, the FDIC paid $525 million to NextBank depositors .
23
In its November 26, 2002 report on NextBank, the OIG estimated that NextBank's failure would cost
24
the FDIC between $300 and $350 million, making it the most costly failure in 2002 .
25
102. The failure of NextBank prompted investigations by the OCC, the FDIC and the SEC .
26
As part of its investigation, on March 1, 2002, the OCC sent a subpoena to E&Y in care of Trauger
27
that required the production of documents related to NextCard by March 25, 2002 . Ex . 3, 39 ; Ex, 2
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-38-
1 at 4 . The subpoena specifically requested E&Y to list any responsive documents that were
2 previously destroyed and to explain the reasons for the destruction of the documents . Ex . 3, ¶39 .
3 103 . In addition, the SEC sent a letter to an E&Y attorney on March 5, 2002 that stated the
4 SEC was conducting an investigation of NextCard and asking E&Y to preserve certain documents,
5 including all working papers prepared in connection with E&Y's audit work for NextCard in 1999,
6 2000 and 2001 . Ex . 3, ¶40 .
7 104 . On March 15, 2002, Trauger sent a letter to members of the NextCard engagement
8 team, including Flanagan, informing them of the OCC subpoena and the SEC's request to preserve
9 documents . Ex . 3, 40 . In the letter, Trauger stated that '" the scope of the subpoena is very broad
10 and includes all workpapers, desk/person files, and emails in your possession ."' Id.
11 105 . Trauger asked Flanagan to collect various NextCard documents responsive to the
12 subpoena. Ex . 3, ¶41 ; Ex . 2 at 4 . Flanagan requested members of the NextCard engagement team to
13 provide him with responsive documents . Ex . 2 at 4 . Flanagan received a zip disk of the former senior
14 auditor for the NextCard engagement which contained her electronic files for the 2000 NextCard
15 audit . Id. When Flanagan informed Trauger of the existence of the zip disk, Trauger told him that it
16 was not important and to get rid of it . Ex . 2 at 4 ; Ex . 3, ¶41 . Flanagan did not provide the zip disk to
17 the OCC but did not destroy it . Ex . 2 at 5 ; Ex . 3, T41 . The zip disk contains NextCard materials
18 prepared during the course of the 2000 audit . Ex . 3, ¶41 .
19 106 . Trauger also told Flanagan to review his computer and to delete any emails or files
20 which reflected the alterations they made to the NextCard audit . Ex . 2 at 4-5 ; Ex . 3, ¶41 . Flanagan
21 reviewed emails and files and deleted at least two items that would have reflected the alterations
22 made to the 2000 audit . Ex . 2 at 5 ; Ex . 3, x;41 .
23 107 . On April 5, 2002, E&Y also produced documents to the OCC in response to a
24 subpoena issued by the OCC on March 5, 2002 . Ex . 3, ¶42 . Included in the production were
25 documents that had been altered by Trauger, Flanagan and Mullen . Id.
26 108 . In approximately January 2003, E&Y personnel, including Trauger, met voluntarily
27 with SEC officials at the SEC's San Francisco, California, offices . Ex . 3, ¶44 . At the meeting, E&Y
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -39-
1
distributed binders containing NextCard working papers including some of the altered documents
2
that E&Y had previously produced to the OCC . Id.
3
109, On April 21, 2003, the SEC sent a subpoena to Trauger requiring him to appear for
4
investigative testimony and to produce documents related to NextCard . Ex. 3, $45. On April 30,
5
2003, Trauger provided testimony to the SEC, and while under oath, described the steps he took in
6
2002 to comply with the OCC subpoena . Id., ¶46 . Trauger testified that he undertook an extensive
7
search for all responsive documents and '"walked the halls for the people in San Francisco"' to mak e
8
sure that all responsive documents were collected in response to the OCC subpoena . Id. Trauger
9
concealed that he, Flanagan and Mullen had altered and destroyed documents in 2002 . Id.
10
C. Trauger and Flanagan Have Admitted E&Y's Participation in the
Scheme to Defrau d
11
110 . As set forth above, Flanagan entered into a Plea Agreement with the United States
12
Attorney wherein he agreed that he corruptly obstructed an examination of NextCard by the OCC
13
and admitted that he and Trauger altered and deleted documents so that the OCC would conclud e
14
E&Y's audit was more soundly based than it actually was . Flanagan also admitted that he withheld
15
and destroyed documents responsive to the OCC's subpoena for the improper purpose of concealin g
16
I the prior alterations from the OCC .
17
111 . According to the Richards Affidavit, in June 2003, Trauger admitted to an E& Y
18
attorney that he made changes to certain NextCard working papers after the documents had been
19
finalized . Ex . 3, ¶47 . Trauger has been arrested and charged with corruptly obstructing the OCC's
20
examination of NextCard and knowingly concealing and covering up a false entry in a record,
21
document and tangible object related to the annual audits and quarterly reviews of the financial
22
statements of NextCard by E&Y with the intent to impede, obstruct and influence the investigatio n
23
[I of NextCard by the SEC .
24
11 VIII . E&Y's GAAS VIOLATION S
25
112 . An independent accountant that certifies a company's financial statements a s
26
11 complying with GAAP assumes a public responsibility transcending any employment relationshi p
27
11 with the client . The independent accountant performing this special function owes ultimat e
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -40-
1
allegiance to the corporation's creditors and stockholders, as well as the investing public . Thi s
2
"public watchdog" function demands that the accountant maintain total independence fr om the client
3
at all times and requires complete fidelity to the public trust .
4
113 . The SEC has repeatedly stressed the impo rt ance of meaningful audits being
5
performed by independent accountants so investors will have confidence in financial reporting . See
6
SEC Accounting Series Release No . 296 (Aug. 20, 1981) . SEC Regulation S-X,17 C .F .R. §§210, et
7
seq., requires public companies to issue audited financial statements that comply with GAAP .
S
Financial statements filed with the SEC that are not prepared in accordance with GAAP are
9
presumed to be misleading. 17 C .F .R . §210 .4-01(a)(1) .
10
114 . The SEC has stressed the importance of meaningful audits being performed b y
11 I independent accountants :
12
16
[T]he capital formation process depends in large part on the confidence of investors
in financial reporting . An investor's willingness to commit his capital to an
impersonal market is dependent on the availability of accurate, material and timely
information regarding the corporations in which he has invested or proposes to
invest . The quality of information disseminated in the securities markets and the
continuing conviction of individual investors that such information is reliable are
thus key to the formation and effective allocation of capital . Accordingly, the audit
function must be meaningfully performed and the accountant's independence not
compromised .
17
SEC Accounting Series Release No . 296 (Aug . 20, 1981) . As set forth above, E&Y's audit was not
18
meaningfully performed and its independence was compromised .
13
14
15
19
115 . The SEC also requires public companies to have their interim fi nancial statement s
20
reviewed by an independent auditor before they are filed with the SEC in the Company's quarterly
21
Report on Form 10-Q . 17 C .F .R . §210.10-01(d) . Thus, E&Y was required to, and did, review
22
NextCard's quarterly financial statements included in the Company's quarterly Reports on Form 10-
23
Q prior to the filing of the Report on Form 10-Q . This requirement was designed to enhance the
24
reliability and credibility of the quarterly financial statements . According to the SEC, E&Y had a
25
policy that required its clients to have reviews of their quarterly financial information as a condition
26
to E&Y's acceptance of the audit engagement . In conducting the review of NextCard's quarterly
27
financial statements, E&Y was required to use professional standards and procedures as established
28
by GAAS . GAAS, as approved and adopted by the American Institute of Certified Publi c
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -41-
1
Accountants ("AICPA"), relate to the conduct of individual audit engagements . Statements on
2
Auditing Standards (codified and referred to as "AU §_") are recognized by the AICPA as the
3
interpretation of GAAS . Regarding E&Y's quarterly reviews, AU §722 required E&Y to :
(a) Identify types of potential material misstatements in NextCard' s interim
4
5
financial information and to consider the likelihood of their occurrence;
6
(b) Select inquiries and analytical procedures that would provide E &Y with a
7
basis for reporting whether material modifications should be made to NextCard 's financial
8
statements to conform with GAAP ;
9
(c) Have sufficient knowledge of NextCard's internal controls as it relates to the
10
preparation of the quarterly financial statements including knowledge of the control environment,
11
risk assessment, control activities, information and communication, and monitoring ;
(d) Read NextCard's quarterly financial statements to consider whether th e
12
13
financial statements comply with GAAP ;
14
(e) Inquire whether there had been changes in NextCard's accounting practices ;
15
(f) Inquire about changes in NextCard's business activities ;
16
(g) Inquire about events subsequent to the date of the interim financia l
17
information that would have a material effect on the presentation of such information ;
18
19
(h) Modify the review procedures to take into consideration the results of auditing
procedures applied during an audit conducted in accordance with GAAS ;
20
(i) Discuss with the appropriate level of management any matter that caused
21
E&Y to believe that the interim financial information, filed or to be filed with a specified regulatory
22
agency, is probable materially misstated as a result of the departure from GAAP ;
{j) Inform NextCard' s audit committee if management does not respond
23
24
appropriately to E&Y' s communications ; and
25
26
(k) Inform the audit committee of any fraud or illegal acts ofwhich E&Y becam e
aware .
27
116 . On their website, E&Y represents that it is a global leader in professional services
28
with the ability to implement a broad array of solutions in audit , tax, corporate finance, transactions,
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -42-
1
online security, enterprise risk management, valuation of intangibles and other critical business
2
performance issues . E&Y boasts it has the knowledge and technology resources, skills and
3
experience to offer clients the services they need, including auditing and accounting advice . E&Y
4
contends that it has tackled critical areas such as regulatory capital requirements, eroding margins,
5
measurement of risk and risk management systems .
6
117 . In fact, E&Y completely failed its public watchdog function and its failure wa s
7
knowing and deliberate . E&Y (1) knowingly issued a false and misleading audit opinion on
8
NextCard's fiscal year 2000 financial statements, (2) reviewed and approved NextCard's materially
9
false and misleading quarterly financial statements before they were filed with the SEC, (3)
10
subsequently altered, deleted and falsified information contained in the audit and review workpapers
11
to conceal its participation in the fraudulent scheme from the OCC and investors, (4) misled the SEC
12
in connection with its investigation of NextCard, and (5) withheld and destroyed documents
13
responsive to a subpoena issued by the OCC to E&Y in an effort to conceal their prior alterations,
14
deletions and falsifications .
15
118. GAAS, as set forth in AU §326 .25, Evaluation ofEvidential Matter, requires auditors
16 I to obtain sufficient and competent evidential matter through inspection, observation, inquiries, an d
17
confirmations to afford a reasonable basis for an opinion regarding the financial statements unde r
18
audit:
19
25
In evaluating evidential matter, the auditor considers whether specific audit
objectives have been achieved . The independent auditor should be thorough in his or
her search for evidential matter and unbiased in its evaluation. In designing audit
procedures to obtain competent evidential matter, he or she should recognize the
possibility that the financial statements may not be fairly presented in conformity
with generally accepted accounting principles or a comprehensive basis of
accounting other than generally accepted accounting principles . In developing his or
her opinion, the auditor should consider relevant evidential matter regardless of
whether it appears to corroborate or to contradict the assertions in the financial
statements . To the extent the auditor remains in substantial doubt about any assertion
of material significance, he or she must refrain from forming an opinion until he or
she has obtained sufficient competent evidential matter to remove such substantial
doubt, or the auditor must express a qualified opinion or a disclaimer of opinion .
26
119 . E&Y's responsibility, as NextCard's independent auditor, was to obtain "[s]ufficien t
27
competent evidential matter .. . to afford a reasonable basis for an opinion regarding the financia l
28
statements under audit" as to "the fairness with which they present, in all material respects, financia l
20
21
22
23
24
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -43-
1 position, results of operations, and its cash flows in conformity with generally accepted accounting
2 principles ." AU §§110, 150 .
3 120. In violation of GAAS, and contrary to the representations in its report on NextCard's
4 2000 financial statements, E&Y did not obtain sufficient competent evidential matter to support
5 NextCard's assertions regarding its income and assets for fiscal 2000, because much of the evidential
6 matter that E&Y gathered, as described above, directly contradicted NextCard's reported results .
7 121 . Given these factors, E&Y should have significantly expanded its audit procedures,
8 modified its reports to be either qualified or adverse and/or considered withdrawing from the
9 engagement . Nonetheless, E&Y issued an unqualified opinion in January 2001, falsely representing
10 that NextCard's financial statements were presented in conformity with GAAP and that its audits
11 had been conducted in conformity with GAAS .
12 122 . In addition, the alteration, destruction and falsification of the audit and review
13 workpapers violated professional auditing standards governing the creation and retention of
14 workpapers as well as those establishing the standards for ethical conduct by auditors . AU §339
15 addresses the preparation and maintenance of workpapers . AU §339.01 states that the information
16 contained in working papers constitutes the principal record of the work that the auditor has done
17 and the conclusions he has reached concerning significant matters . AU §339 .0 8 requires the auditor
18
to "adopt reasonable procedures for safe custody of his working papers and retain them for a period
19 sufficient to satisfy any pertinent legal requirements of records retention . "
20 123 . The AICPA Code of Professional Conduct, specifically, ET §§51-54 and 56, provide
21 additional professional standards for auditors . These sections require a high level of professional
22 ethics and integrity from public accountants .
23 124. E&Y violated the foregoing GAAS provisions and the AICPA Code of Professional
24 Conduct by their alteration, destruction and falsification of the NextCard audit and review
25 workpapers.
26 125 . Due to E&Y's false statements and failure to identify and modify its reports to
27 identify NextCard's false financial reporting, E&Y also violated the following GAAS standards :
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -44-
1
2
3
4
5
6
7
8
(a) The first general standard is that the audit should be performed by persons
having adequate technical training and proficiency as auditors ;
(b) The second general standard is that the auditors should maintain an
independence in mental attitude in all matters relating to the engagement ;
(c) The third general standard is that due professional care is to be exercised in
the performance of the audit and the preparation of the report ;
(d) The first standard of field work is that the audit is to be adequately planned
and that assistants should be properly supervised ;
9
(e) The second standard of field work is that the auditor should obtain a sufficient
10
understanding o f internal controls so as to plan the audit and determine the nature, timing and extent
11
of tests to be performed ;
12
(f) The third standard of field work is that sufficient competent evidential matter
13
is to be obtained to afford a reasonable basis for an opinion on the financial statements under audit ;
14
(g) The first standard of reporting is that the report state whether the financial
15
16
17
18
19
20
statements are presented in accordance with GAAP ;
(h) The second standard of reporting is that the report shall identify circumstances
in which GAAP has not been consistently observed ;
(i) The third standard of reporting is that informative disclosures are regarded as
reasonably adequate unless otherwise stated in the report ; and
(j) The fourth standard of reporting is that the report shall contain an expression
21
of opinion or the reasons why an opinion cannot be expressed .
22
IX. GAAP VIOLATION S
23
126 . From its audits and reviews, E&Y knew that NextCard violated GAAP and SEC rules
24
by failing to properly report the value of its loans and accrued finance charges to reflect the large
25
amounts of uncoIlectible assets in NextCard's balance sheet.
26
127 . NextCard reported the following financial results for 2000 and 2001 :
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -45-
03/31 /00
06/30 /00
09/30100
12131/00
03/31101
06/30/0 1
Net Loss
($17 .7) M
($24.5) M
($20 .3) M
($19 .4) M
($16 .6) M
($14 .4) M
Loss Per Share
($0 .34)
($0 .46)
($0.38)
($0 .37)
($0 .31)
($0 .27 )
Allowance for
Loan Losses
2.84%
3.16%
3.9%
3.16%
5 .08%
6.10%
I
2
3
4
5
6
NextCard included these "reported" results in press releases and in Repo rts on Form 10 -Qs that were
7
reviewed and approved by E&Y prior to being filed with the SEC .
8
128 . These financial statements and the statements about them were false and misleading,
9
10 as such financial information was not prepared in conformity with GAAP, nor was the financial
1 1 information a fair presentation of the Company's operations due to the Company ' s improper
accounting for its investment in NextBank, in violation of GAAP and SEC rules .
12
129 . GAAP are those pri nciples recognized by the accounting profession as the
13
14 conventions , rules and procedures necessary to defi ne accepted accounting practice at a particular
15 time . Regulation S-X (17 C .F .R . §210 .4-01 ( a)(1)) states that fi nancial statements filed with the SEC
16 which are not prepared in compliance with GAAP are presumed to be misleading and inaccurate .
Regulation S-X requires that interim fi nancial statements must also comply with GAAP, with the
17
18 exception that inte rim financial statements need not include disclosure which would be duplicative
19 of disclosures accompanying annual financial statements . 17 C .F .R . §210.10-01(a) .
20 130 . According to GAAP, as set forth in Statement of Financial Accounting Standards
21 ("SFAS") No . 114, Accounting by Creditors for Impairment of a Loan, a loan is impaired when it is
probable that a creditor will be unable to collect all amounts under contract . SFAS No . 114, ¶8
22
(amended by SFAS No . 118) . GAAP, as descri bed by FASB Statement of Concepts No . 5, requires
23
24 that a loss be recorded for assets where expected benefits of an asset have been eliminated .
131, During the Class Period, NextCard failed to record adequate reserves for uncollectible
25
26 loans and accrued finance charges even as its ri sk of non-recove ry increased . Because of
27 NextCard' s extension of credit through the Internet and its lack of history with its customers, it
28 needed to use conse rv ative estimates when valuing its extremely risky po rtfolio of credit card loan
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
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1 receivables and interest receivables . During the Class Period, it was experiencing increasing
2 delinquencies and charge-offs, with charge-offs increasing to $13 .2 million in the first six months of
3 2001 from $4 .4 million in the first six months of 2000 .
4 132 . Ultimately, NextCard substantially increased loan loss reserves from $31 million on
5 June 30, 2001 to $71 .6 million on September 30, 2001 . The Company also has written off $5 .6
6 million for uncollectible accrued finance charges and fees and reclassified fraud losses as credit
7 losses. NextBank has also written off $35 .7 million of improperly capitalized acquisition costs .
8 GAAP, SFAS No . 91, required NextBank to expense the loan acquisition costs . The Company also
9 overstated earnings by failing to write down its retained interest in securitized loans . GAAP (SFAS
10 No . 115) required NextCard to write down the Company's retained interest . After the Class Period,
11 investors learned that the OCC required the Company to write down its retained interest by $22
12 million.
13 133 . Due to these accounting improprieties, the Company presented its financial results
14 and statements in a manner which violated GAAP, including the following fundamental accounting
15 principles :
16 (a) The principle that interim financial reporting should be based upon the same
17 accounting principles and practices used to prepare annual financial statements was violated
18 (Accounting Principles Board Opinion ("APB") No . 28, ¶10) ;
19 (b) The principle that financial reporting should provide information that is useful
20 to present and potential investors and creditors and other users in making rational investment, credit
21 and similar decisions was violated (FASB Statement of Concepts No . 1, ¶34) ;
22 (c) The principle that financial reporting should provide information about the
23 economic resources of an enterprise, the claims to those resources, and effects of transactions, events
24 and circumstances that change resources and claims to those resources was violated (FASB
25 Statement of Concepts No . 1, ¶40) ;
26 (d) The principle that financial reporting should provide information about how
27 management of an enterprise has discharged its stewardship responsibility to owners (stockholders)
28 for the use of enterprise resources entrusted to it was violated . To the extent that management offers
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS - -47-
securities of the enterprise to the public, it voluntarily accepts wider responsibilities for
accountability to prospective investors and to the public in general (FASB Statement of Concept s
I No . 1, ¶50);
(e) The principle that financial reporting should provide information about an
enterprise's financial performance during a period was violated . Investors and creditors often use
information about the past to help in assessing the prospects of an enterprise . Thus, although
7
investment and credit decisions reflect investors' expectations about future enterp rise performance,
8
those expectations are commonly based at least partly on evaluations of past enterprise performance
9
(FASB Statement of Concepts No. 1, ¶42) ;
10
(f) The pri nciple that financial repo rting should be reliable in that it represents
11
what it purports to represent was violated . That information should be reliable as well as relevant i s
12
a notion that is central to accounting (FASB Statement of Concepts No . 2, ¶¶158-59) ;
13
(g) The principle of completeness, which means that nothing is left out of th e
14
information that may be necessary to insure that it validly represents underlying events and
15
conditions was violated (FASB Statement of Concepts No . 2, ¶79); an d
16
(h) The principle that conservatism be used as a prudent reaction to uncertainty t o
17 I try to ensure that uncertainties and risks inherent in business situations are adequately considere d
18
was violated . The best way to avoid injury to investors is to try to ensure that what is reported
19
represents what it purports to represent (FASB Statement of Concepts No . 2, ¶¶95, 97) .
20
134 . Further, the undisclosed adverse information concealed by defendants during the
21
Class Period is the type of information which, because of SEC regulations, regulations of th e
22
national stock exchanges and customary business practice, is expected by investors and securities
23
analysts to be disclosed and is known by corporate officials and their legal and financial advisors to
24
be the type of information which is expected to be and must be disclosed .
25
26
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
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1
X. FALSE AND MISLEADING STATEMENTS DURING THE CLASS
PERIO D
2
A. False and Misleading Statements Regarding NextCard' s 1Q00 Results
3
135 .
False Statement : On April 19, 2000 NextCard issued a press release announcing the
4
Company's financial results for 1 Q00 . Those financial results were repeated to the market in the
S
Company's Report on Form 10-Q which was reviewed by E&Y prior to being filed with the SEC on
6
May 15, 2000 . NextCard reported a provision for loan losses expense of $8 .6 million, net interest
7
income after provision for loan losses of $565,000 and a net loss of $17 .7 million . In addition,
8
NextCard reported that delinquent loans were $11 .7 million, or 1 .82% of managed loans and that
9
charge-offs were $2 .5 million or 1 .93% of average managed loans .
10
136 .
Reasons Why and E&Y's Knowledge of Why NextCard's Reported Financial Results
11
Were Materially False and Misleading : E&Y knew the financial results reported byNextCard were
12
materially false and misleading for the reasons set forth in ¶'133-81 . Specifically,
13
(a) E&Y knew that the loan loss provision expense was understated, that net
14
interest income after provision for loan losses was overstated and that the net loss was understate d
15
due to the Company's accounting improprieties, i .e., failing to establish sufficient loan loss
16
allowances and improperly capitalizing loan acquisition costs ;
17
(b)
E&Y also knew that NextCard materially understated the level of delinquen t
18
loans and charge-offs by improperly classifying credit losses as fraud losses ;
19
(c) At March 31, 2000 NextBank reported risk based capital of $82 .075 million,
20
risk weighted assets of $696 .3 million and a risk based capital ratio of 11 .79% . E&Y knew risk
21
22
based capital was overstated because of the failure to establish sufficient loan loss allowances an d
the improper capitalization of credit card acquisition costs . E&Y knew risk weighted assets were
23
understated by $300 million because NextBank improperly excluded $300 million of loans sold that
24
did not qualify for low level recourse treatment . As reported by the OCC, they did not qualify for
25
26
low level recourse treatment because the Company was buying back certain loans ; and
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -49-
1
(d) E&Y's knowledge is also shown by their alteration, falsification and
2
destruction of their audit and review workpapers after E&Y knew the OCC had challenged E&Y's
3
audit procedures and requested E&Y's audit and review workpapers .
4
B. False and Misleading Statements Regarding NextCard's 2Q00 Results
5
137 .
False Statement : On July 27, 2000 NextCard issued a press release announcing the
6
Company's financial results for 2Q00 . Those financial results were repeated to the market in the
7
Company's Report on Form 10-Q which was reviewed by E&Y prior to being filed with the SEC on
8
August 14, 2000 . NextCard reported a provision for loan losses expense of $9 .6 million, net interest
9
income after provision for loan losses of $158,000 and a net loss of $24 .5 million. In addition ,
10
NextCard reported that delinquent loans were $22 .3 million, or 2 .68% of managed loans and tha t
11
charge-offs were $4 .1 million or 2 .21% of average managed loans .
12
138 . Reasons )n and E&Y's Knowledge of Why the NextCard's Reported Financial
13
Results Were Materially False and Misleading : E&Y knew that the financial results reported by
14
NextCard were materially false and misleading for the reasons set forth in ¶ (33-81 . Specifically,
15
(a) E&Y knew that the loan loss provision expense was understated, that net
16
interest income after provision for loan losses was overstated and that the net loss was understated
17
due to the Company's accounting improprieties, i.e., failing to establish sufficient loan loss
18
allowances and improperly capitalizing loan acquisition costs ;
(b) E&Y also knew that NextCard materially understated the level of delinquen t
19
20
loans and charge-offs by improperly classifying credit losses as fraud losses ;
21
(c) In its SEC Report on Form 10-Q and Call Report for 2Q00, NextBan k
22
reported risk based capital of $109 .9 million, risk weighted assets of $897 million and a risk based
23
capital ratio of 12 .26%. E&Y knew risk based capital was overstated because of the failure t o
24
establish sufficient loan loss allowances and the improper capitalization of credit card acquisition
25
costs . E&Y knew risk weighted assets were understated by $300 million because NextBank
26
improperly excluded $300 million of loans sold that did not qualify for low level recourse treatment .
27
They did not qualify for low level recourse treatment because the Company was buying back certai n
28
loans ; and
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
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-50-
I (d) E&Y's knowledge is also shown by their alteration, falsification and
2 destruction of their audit and review workpapers after E&Y knew the OCC had challenged E&Y's
3 audit procedures and requested E&Y's audit and review workpapers .
4 C. False and Misleading Statements Regarding NextCard' s 3Q00 Results
5 139 .
False Statement : On October 25, 2000 NextCard issued a press release announcing
6 the Company's financial results for 3Q00 . Those financial results were repeated to the market in the
7 Company's Report on Form 10-Q which was reviewed by E&Y prior to being filed with the SEC on
8 November 14, 2000 . NextCard reported a provision for loan losses expense of $16 .1 million, net
9 interest income after provision for loan losses of negative $3 .5 million and a net loss of $20 .3
10 million . In addition, NextCard reported that delinquent loans were $36 .1 million, or 3 .3% of
11 managed loans and that charge-offs were $6 .4 million or 2 .67% of average managed loans .
12 140 . Reasons Why and E&Y's Knowledge of Why the NextCard's Reported Financial
13
Results Were Materially False and Misleading : E&Y knew the financial results reported by
14 NextCard were materially false and misleading for the reasons set forth in ¶ 33-81 . Specifically,
15 (a) E&Y knew that the loan loss provision expense was understated, that net
16 interest income after provision for loan losses was understated and that the net loss was understated
17 due to the Company's accounting improprieties, i.e., failing to establish sufficient loan loss
18 allowances and improperly capitalizing loan acquisition costs . Indeed, E&Y deleted all references in
19 the summary review memorandum prepared during its review of NextCard's 3Q00 financial
20 statements that showed E&Y knew NextCard's capitalization of loan acquisition costs violated
21 GAAP (SFAS No . 91) ;
22 (b) E&Y also knew that NextCard materially understated the level of delinquent
23 loans and charge-offs by improperly classifying credit losses as fraud losses ;
24 (c) In its SEC Report on Form 10-Q and Call Report for 3Q00, NextBank
25 reported risk based capital of $135 .5 million, risk weighted assets of $1 .2 billion and a risk based
26 capital ratio of 11 .37% . E&Y knew risk based capital was overstated because of the failure to
27 establish sufficient loan loss allowances and the improper capitalization of credit card acquisition
28 costs . E&Y knew risk weighted assets were understated by $520 million because NextBank
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
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improperly excluded $520 million of loans sold that did not qualify for low level recourse treatment .
2
They did not qualify for low level recourse treatment because the Company was buying back certai n
3
loans ; and
4
(d) E&Y's knowledge is also shown by their alteration, falsification and
5
destruction of their audit and review workpapers after E&Y knew the OCC had challenged E&Y' s
6
audit procedures and requested E&Y's audit and review workpapers .
7
D. False and Misleading Statements Regarding NextCard 's 4Q00 and
Fiscal Year 2000 Results
8
141 .
False Statement : On January 24, 2001 NextCard issued a press release announcing the
9
Company's financial results for 4Q00 and fiscal year 2000 . Those financial results were repeated to
10
the market in the Company's Report on Form 10-K filed with the SEC on April 2, 2001 . Included in
11
the Report on Form 10-K was E&Y's January 23, 2001 audit opinion that represented NextCard's
12
financial results conformed with GAAP and that E&Y conducted its audit in accordance wit h
13
GAAS . NextCard reported a provision for loan losses expense of $22 .8 million, net interest income
14
after provision for loan losses of negative $10 .1 million and a net loss of $19 .4 million . In addition,
15
NextCard reported that delinquent loans were $51 .4 million, or 3 .92% of managed loans and that
16
charge-offs were $9 .3 million or 3 .10% of average managed loans . For the year ending December
17
31, 2000, NextCard reported a provision for loan loss expense of $57 .1 million, net interest income
18
after provision for loan losses of $negative $12 .9 million and a net loss of $81 .9 million . In addition,
19
NextCard reported that delinquent loans were $51 .4 million or 3 .92% of managed loans and that
20
charge-offs were $22 .4 million or 2 .62% of average managed loans .
21
142 . Reasons Why and E&Y's Knowledge of Why the NextCard's Reported Financia l
22
I Results and E&Y's Janua
31, 2001 Audit Opinion Were Materially False and Misleadin : E&Y
23
knew its audit opinion and the financial results reported by NextCard were materially false an d
24
misleading for the reasons set forth in ¶1133-81 . Specifically,
25
(a) E&Y knew NextCard's fiscal year 2000 financial statements did not compl y
26
I with GAAP as E&Y represented in its January 23, 2001 audit opinion . E&Y knew that the loan los s
27
provision expense was understated, that net interest income after the provision for loan losses wa s
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
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-52-
1 overstated and that the net loss was understated due to the Company's accounting improprieties .
2 E&Y knew that NextCard had improperly reduced the charge-off rate that was used to determine the
3 loan loss provision expense by improperly classifying credit losses as fraud losses, improperly
4 selling delinquent loans before they had to be charged off and by reducing the charge-off rate based
5 on an unproven and purportedly newly implemented collection policy .
6 (b) E&Y also knew that the Company's net loss was understated due to the
7 Company's improper practice of capitalizing loan acquisition costs . In fact, E&Y deleted all
8 references in the summary review memorandum prepared during its review of NextCard's 3Q00
9 financial statements that showed E&Y knew NextCard's capitalization of loan acquisition costs
10 violated GAAP (SFAS No . 91) . E&Y also deleted the references in its fiscal year 2000 audit
11 workpapers that disclosed the practice was inconsistent with the majority of its industry peers .
12 (c) E&Y also knew that the level of delinquencies and charge-offs reported by
13 NextCard were substantially understated and contrary to the actual levels included in E&Y's audit
14 workpapers . Indeed, E&Y altered its fiscal year 2000 workpapers after they were requested by the
15 OCC and changed the level of delinquencies and charge-offs to match the false amounts reported by
16 NextCard . E&Y then destroyed the original workpapers to coverup and conceal their knowledge of
17 and participation in the fraud;
18 (d) Based on the above, E&Y knew the January 23, 2001 audit opinion was
19 materially false and misleading . Indeed, E&Y altered, destroyed and falsified their audit working
20 papers to conceal their knowledge that NextCard was reporting materially false and misleading
21 financial results .
22 (e) In its SEC Report on Form 10-K and Call Report for 4Q00, NextBank
23 reported risk based capital of $187 million, risk weighted assets of $1 .2 billion and a risk based
24 capital ratio of 15 .73%. E&Y knew risk based capital was overstated because of the failure to
25 establish sufficient loan loss allowances and the improper capitalization of credit card acquisition
26 costs . E&Y knew risk weighted assets were understated by $762 million because NextBank
27 improperly excluded $762 million of loans sold that did not qualify for low level recourse treatment .
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-53-
{
1
They did not qualify for low level recourse treatment because the Company was buying back certain
2 [ loans .
3
E. False and Misleading Statements Regarding NextCard's 1Q01 Results
4
143 .
False Statem ent: On April 25, 2001 NextCard issued a press release announcing the
5
Company's financial results for I Q01 . Those financial results were repeated to the market in the
6
Company's Report on Form 10-Q which was reviewed by E&Y prior to being filed with the SEC on
7
May 15, 2001 . NextCard reported a provision for loan losses expense of $20 .0 million, net interest
8
income after provision for loan losses of negative $13 .1 million and a net loss of $16 .6 million. In
9
addition, NextCard reported that delinquent loans were $75 .7 million, or 4.75% of managed loans
10
and that charge-offs were $14 .7 million or 3 .99% of average managed loans .
11
144 . Reasons Why and E&Y's Knowledge of Why the NextCard' s Reported Financial
12
Results Were Materially False and Misleading : E&Y knew the financial results reported b y
13 [ NextCard were materially false and misleading for the reasons set forth in ¶¶33-81 . Specifically,
14
(a) E&Y knew NextCard' s 1 Q01 fi nancial statements did not comply with GAAP
15
as represented in the Report on Form I O-Q . E&Y knew that the loan loss provision expense was
16
understated, that net interest income after the provision for loan losses was overstated and that the
17
net loss was understated due to the Company's accounting improprieties . E&Y knew that NextCard
18
had improperly reduced the charge-off rate that was used to determine the loan loss provision
19
expense by improperly classifying credit losses as fraud losses, improperly selling delinquent loans
20
before they had to be charged off and by reducing the charge-off rate based on an unproven and
21
purportedly newly implemented collection policy . In fact, E&Y's 1 Q01 summary review
22
memorandum originally stated that NextCard's assumptions about the loan recovery rate were
23
"aggressive" but changed the workpaper to state that the assumption were "conservative" when the
24
OCC requested the workpapers . In addition, E&Y deleted a reference in the I Q01 summary review
25
memorandum that stated NextCard's loan loss reserves were at the low end of the acceptable range
26
for reserves ;
27
(b) E&Y also knew that the Company's net loss was understated due to the
28
Company's improper practice of capitalizing loan acquisition costs . In fact, E&Y deleted all
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS - -54-
1 references in the summary review memorandum prepared during its review of NextCard's 3Q00
2 financial statements that showed E&Y knew NextCard's capitalization of loan acquisition costs
3 violated GAAP (SFAS No. 91) . E&Y also deleted the references in its fiscal year 2000 audit
4 workpapers that disclosed the practice was inconsistent with the majority of its industry peers ; and
5 (c) In its SEC Report on Form 10-Q and Call Report for 1Q01, NextBank
6 reported a risk based capital of $188 million, risk weighted assets of $1 .5 billion and a risk based
7 capital ratio of 12 .6% . E&Y knew risk based capital was overstated because of the failure to
8 establish sufficient loan loss allowances and the improper capitalization of credit card acquisition
9 costs . E&Y knew risk weighted assets were understated by $1 .2 billion because NextBank
10 improperly excluded $1 .2 billion of loans sold that did not qualify for low level recourse treatment .
11 They did not qualify for low level recourse treatment because the Company was buying back certain
12 loans .
13 F. False and Misleading Statements Regarding NextCard's 2Q01
Financial Results
14
145 .
False Statement : On July 25, 2001 NextCard issued a press release announcing the
15
Company's financial results for 2Q01 . Those financial results were repeated to the market in the
16
Company's Report on Form 10-Q which was reviewed by E&Y prior to being filed with the SEC on
17
August 14, 2001 . NextCard reported a provision for loan losses expense of $18 .5 million, net
18
interest income after provision for loan losses of negative $11 .4 million and a net loss of $14 .4
19
million. In addition, NextCard reported that delinquent loans were $94 .0 million, or 5 .25% of
20
managed loans and that charge-offs were $20 .7 million or 4 .92% of average managed loans .
21
146 . Reasons l and E&Y's Knowledge of Why the NextCard's Reported Financial
22
Results Were Materially False and Misleading : E&Y knew the financial results reported by
23
NextCard were materially false and misleading for the reasons set forth in ¶x[33-81 . Specifically,
24
(a) E&Y knew NextCard's 2Q01 financial statements did not comply with GAAP
25
as represented in the Report on Form 10-Q . E&Y knew that the loan loss provision expense was
26
understated, that net interest income after the provision for loan losses was overstated and that the
27
28 net loss was understated due to the Company's accounting improprieties . E&Y knew that NextCard
CONNSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
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-55-
1 had improperly reduced the charge-off rate that was used to determine the loan loss provision
2 expense by improperly classifying credit losses as fraud losses, improperly selling delinquent loans
3 before they had to be charged off and by reducing the charge-off rate based on an unproven and
4 purportedly newly implemented collection policy . In fact, E&Y's I Q01 summary review
5 memorandum originally stated that NextCard's assumptions about the loan recovery rate were
6 "aggressive" but changed the workpaper to state that the assumption were "conservative" when the
7 OCC requested the workpapers . In addition, E&Y deleted a reference in the 1Q01 summary review
8 memorandum that stated NextCard's Ioan loss reserves were at the low end of the acceptable range
9 for reserves . E&Y also significantly altered the 2Q01 summary review memorandum to conceal its
10 knowledge that NextCard's financial results were not reported in accordance with GAAP ;
11 (b) E&Y also knew that the Company's net loss was understated due to the
12 Company's improper practice of capitalizing loan acquisition costs . In fact, E&Y deleted all
13 references in the summary review memorandum prepared during its review of NextCard's 3Q00
14 financial statements that showed E&Y knew NextCard's capitalization of loan acquisition costs
15 violated GAAP (SFAS No . 91) . E&Y also deleted the references in its fiscal year 2000 audit
16 workpapers that disclosed the practice was inconsistent with the majority of its industry peers ; and
17 (c) In its SEC Report on Form 10-Q and Call Report for 2Q01, NextBank
IS
reported risk based capital of $187 .2 million, risk weighted assets of $1 .1 billion and a risk based
19 capital ratio of 17 .35% . E&Y knew risk based capital was overstated because of the failure to
20 establish sufficient loan loss allowances and the improper capitalization of credit card acquisition
21 costs . E&Y knew risk weighted assets were understated by $1 .2 billion because NextBank
22 improperly excluded $1 .2 billion of loans sold that did not qualify for low level recourse treatment .
23 X1 . CLASS ACTION ALLEGATION S
24 147. This is a class action on behalf of purchasers of NextCard publicly traded securities
25 during the Class Period (the "Class") . Excluded from the class are officers and directors of the
26 Company, the NextCard defendants and E&Y, as well as their families and affiliates . Class
27 members are so numerous that joinder of them is impracticable .
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-56-
1 148 . Common questions of law and fact predominate and include whether defendant :
2 (i) violated the Exchange Act; (ii) omitted and/or misrepresented material facts ; (iii) knew or
3 recklessly disregarded that their statements were false; and (iv) artificially inflated the prices of
4 NextCard's publicly traded securities and the extent of and appropriate measure of damages .
5 149 . Plaintiffs' claims are typical of those of the class . Prosecution of individual actions
6 would create a risk of inconsistent adjudications . Plaintiffs will adequately protect the interests of
7 the Class . A class action is superior to other available methods for the fair and efficient adjudication
8 of this controversy .
9 XII . COUNT I
10 VIOLATIONS OF SECTION 10(b) OF THE EXCHANGE ACT AND RULE
10b-5 PROMULGATED THEREUNDER AGAINST E&Y
11
150 . Plaintiffs repeat and reallege each of the allegations set forth in the foregoing
12
paragraphs . This Count is brought pursuant to § 10(b) of the Exchange Act, and Rule 1 Ob-5(a)-(c)
13
promulgated thereunder, on behalf of all purchasers of NextCard Securities stock on the open market
14
during the Class Period .
15
151 . Throughout the Class Period, E&Y, by the use and means of instrumentalities of
16
interstate commerce and/or of the mails, made or substantially participated in the making of false
17
and misleading statements and omissions, all of which caused the market price ofNextCard common
18
stock to be artificially inflated throughout the Class Period . As detailed herein, defendant E&Y's
19
false and misleading statements during the Class Period included the following :
20
(a) The statement in NextCard's 2000 Report on Form 10-K filed with the SEC
21
on April 2, 2001, incorporating with permission E&Y's clean audit opinion stating that E&Y had
22
audited NextCard's consolidated balance sheets in accordance with GAAS and that, based on its
23
24
examination, the financial statements presented fairly, in all material respects, NextCard's
1
consolidated financial position .
25
26 152 . In addition to making the above false statement, defendant E&Y substantially
participated in making and approved of the false statements contained in NextCard's quarterly
27
Reports on Form 10-Q, which were filed with the SEC on May 15, 2000, August 14, 2000,
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-57-
1 November 14, 2000, May 15, 2001 and August 14, 2001, stating that the quarterly financial
2 statements and information had been prepared in accordance with GAAP and SEC rules and
3 regulations .
4 153 . In addition to making and substantially participating in making the above false
5 statements, defendant E&Y employed a device, scheme or artifice to defraud and engaged in acts,
6 practices and a course of business that operated as a fraud or deceit upon sellers or purchasers of
7 NextCard securities, as described above.
8 154 . E&Y is vicariously liable for the acts and omissions of its partners and employees,
9 including Trauger, Flanagan and Mullen, and their acts as complained of herein, were committed
10 within the scope, and in furtherance of, their positions at E&Y .
11 155 . Defendant E&Y acted with scienter throughout the Class Period, in that they knew or
12 were deliberately reckless in not knowing of the misrepresentations and omissions of material facts,
13 and of the course of business or device, scheme or artifice that operated as a fraud on sellers or
14 purchasers of NextCard securities, as described above .
15 156 . As a result of these deceptive practices and false and misleading statements and
16 omissions, the market price of NextCard stock was artificially inflated during the Class Period . In
17 ignorance of the false and misleading nature of the representations and omissions described above
18 and the deceptive and manipulative devices employed by the defendants, plaintiffs and the other
19 members of the Class, in reliance on either the integrity of the market or directly on the statements
20 and reports of defendants, purchased NextCard securities at artificially inflated prices .
21 157 . Had plaintiffs and the other members of the Class known of the material adverse
22 information not disclosed by defendants, or been aware of the truth behind defendants' material
23 misstatements, they would not have purchased NextCard common stock at artificially inflated prices .
24 158 . By virtue of the foregoing, E&Y have violated § 10(b) of the Exchange Act and Rule
25 lOb-5(a)-(c) promulgated thereunder .
26 159. Class members were damaged as they paid artificially inflated prices for NextCard's
27 publicly traded securities in reliance on the integrity of the market.
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-58-
PRAYER FOR RELIE F
1 1
2
3
4
5
6
7
WHEREFORE, plaintiffs, on behalf of themselves and the class, pray for judgment as
follows:
A. Declaring this action to be a class action properly maintained pursuant to Rule 23 of
the Fed. R. Civ . P.;
B . Awarding plaintiffs and other members of the class damages together with interes t
thereon ;
8
C . Awarding plaintiffs and other members of the class costs and expenses of this
9
litigation, including reasonable attorneys' fees, accountants' fees and experts' fees and other costs
10
11
12
and disbursements ; an d
D . Awarding plaintiffs and other members of the class such equitable/injunctive or other
and further relief as may be just and proper under the circumstances .
JURY DEMAND
13
14
Plaintiffs demand a tri al by jury.
15
J DATED: October 30, 2003
16 ''.
17
MILBERG WEISS BERSHAD
HYNES & LERACH LLP
JEFFREY W . LAWRENCE
CHRISTOPHER P . SEEFER
18
19
REY W . LAWRENCE
20
21
22
23
24
25
26
100 Pine Street , Suite 260 0
San Francisco , CA 94111
Telephone : 415/288-4545
415/288-4534 (fax)
MILBERG WEISS BERSHAD
HYNES & LERACH LLP
WILLIAM S . LERACH
401 B Street, Suite 1700
San Diego , CA 92101
Telephone : 619/231-1058
619/231-7423 (fax )
27
28
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-59-
1
BERNSTEIN LITOWITZ BERGER &
GROSSMANN LLP
ALAN SCHULMAN
12544 High Bluff Drive , Suite 150
San Diego , CA 9213 0
Telephone : 858/793-0070
858/793-0323 (fax)
2
3
4
5
Attorneys for Plaintiffs
6
I T :\P eadingsSF NextCard\CPT_againstE&Y .doc
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4
CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FO R
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-60-
1
2
3
CERTIFICATION OF INTERESTED ENTITIES OR PERSON S
Pursuant to Civil L .R. 3-16, the undersigned certifies that as of this date , other than the
named parties, there is no such interest to report .
4
Y OF RECORD FO R
LA IFFS M. RICHARD ANDREWS
and JACKSONVILLE POLICE & FIRE
PENSION FUND
5
6
7
T:\P leadingsSF \NextCard\CPT_ againstE&Y .doc
8
9
10 1.
ii
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CONSOL CLASS ACTION COMPLAINT AGAINST ERNST & YOUNG FOR
VIOLATIONS OF FEDERAL SECURITIES LAWS -
-61-
CERTIFICATION OF NAMED PLAINTIFF
PURSUANT TO FEDERAL SECURITIES LAW S
1
2
3
M . Richard Andrews ("Plaintiff") declares :
4
1 . Plaintiff has reviewed a complaint and authorized its filing .
5
2 . Plaintiff did not acquire the security that is the subject of this action at the
6 direction of plaintiff's counsel or in order to participate in this private action or any
7 other litigation under the federal securities laws .
3 . Plaintiff is willing to serve as a representative party on behalf of the
8
9 class, including providing testimony at deposition and trial, if necessary .
4. Plaintiff has made the following transaction(s) during the Class Period in
10
11 the securities that are the subject of this action :
12
13
Acquisitions :
Date Acquired
14
15
16
17
18
19
20'
21 1 Sales:
Number of Share s
Acquired
Acquisition Price Pe r
Share
!26/2000
500
$1 1
3,500
$1 1
/26/2000
1,000
$1 1
X26/2000
8/28/2000
5,000
$6.687 5
10/20/2000
2,500
8.00
5.562 5
12/ 19/2000
,800
5.43 7 5
12119/2000
1,200
12/19/2000 1,000 $5 .50
3/2/2001 5,000 $9 .437 5
6/18/2001
6,000 7 . S S
Number of Shares Selling Price Per
Date Sold Sold Shar e
22
23
24
25
5 . During the three years prior to the date of this Certificate, Plaintiff has
26 not sought to serve or served as a representative party for a class in an action filed
27 under the federal securities laws except as detailed below :
28
T\( srlrfn5f\i ;rvt~~r1r. nrrc+.( rRTtF fC ~TI~1 f F nNtlR1 We t,
i1~RF ,1rF 'T( 4Rn PVC CF(' IIIC
1
2
In re NextCard Securities Litigation , No. C-01-2 ] 029-1F(RS)
6. The Plaintiff will not accept any payment for serving as a representative
3 party on behalf of the class beyond the Plaintiff' s pro rata share of any recovery,
4 except such reasonable costs and expenses (including lost wages) directly relating to
5 the representation of the class as ordered or approved by the cou rt.
6
I declare under penalty of perjury that the' foregoing is true and correct .
7 Executed this 30 day of OGrao .,z-
, 2003.
8
9
M . Richard Andrews
101
11
12
13
14
IS
16
17
18
19
20
21
22
23
24
25
26
27
28
T tiC'm$rTnfo5FlNCK(Card Cafrer,CERIIT :lCA'rICN OF ANDREWS.IQC -
IN R,E NZMARD. INC SEC. LITIG,
I
CERTIFICATIO N
John Keane, on behalf of Jacksonville Police & Fire Pension Fund, declares as to the claims
asserted under the federal securities law, that :
I have reviewed a complaint filed in this matter .
2. Jacksonville Police & Fire Pension Fund did notpurchase the securities that are the
subject of this action at the direction of its counsel, Bernstein Litowitz Berger & Grossmann
LLP, or to participate in this action .
3. Jacksonville Police & Fire Pension Fund is willing to serve as lead plaintiff and class
representative on behalf of the class, including providing testimony at deposition and trial, if
necessary . Jacksonville Police & Fire Pension Fund understands the duties and responsibilities
of a Lead Plaintiff under the Private Securities Litigation Reform Act .
4. Jacksonville Police & Fire Pension Fund has retained the Law Finn of Bernstein Litowitz
Berger & Grossmann LLP to represent it in this matter and to act as lead counsel in the event that
Jacksonville Police & Fire Pension Fund is appointed a lead plaintiff .
5. Jacksonville Police & Fire Pension Fund's transactions in NextCard, Inc . securities that
are the subject of this action are in the chart included herein .
6 . During the three years prior to the date of this Certification, Jacksonville Police & Fire
Pension Fund has served or has sought to serve as a representative party for a class in the
following actions filed under the federal securities law :
In re NextCard Securities Litigatio n
In re El Paso Corporation Securities Litigation
In re ADA C Laboratories, Inc. Securities Litigatio n
7 . Jacksonville Police & Fire Pension Fund initially sought to serve as a representative party
for a class in the following actions filed under the federal securities law, but either withdrew its
application or its application was denied in favor of other investors with more sign ificant losses : .
In re Claruc Corp. Securities Litigatio n
In re Federal Horne Loan Mortgage Securities Litigatio n
8. Jacksonville Police & Fire Pension Fund will not accept any payment for serving as the
lead plaintiff on behalf of the class beyond the pro rata share of any recovery, except such
reasonable costs and expenses (including lost wages) relating to the representation of the class as
ordered or approved by the court.
I
I declare under penalty of perjury that the foregoing is true and correct, Executed this a day
of October, 2003 .
John Keane
Jacksonville Police & Fire Pension Fund
Jacksonville
NextCard (NXCD)
Class period :- 3/30/00 -10130/0 1
Transaction
Buy
Sale
Buy
Buy
t0DMk%PCn0Mb!b=%I MM
Date
3/21/01
5/1/01
8/17/01
8128101
Amount
18,600
Price Per Share
$7,9 9
9,700
S10 .68
10,700
5,200
$9 .5 3
$9.1 6
Exhibit 1
f5
MATERIAL LOSS REVIEW
OF
NEXTBANK, N A
OtG-O3-O 24. NOVEMBER 26 . 200 2
77
Z-1
,Ik-
General.
•-'TM Department of the Treasury
I
Content s
Audit Report . . .. . . . . . .. . . .. . . . . . .. .. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . .. . . . . . . . . . . . . . . . . .. . . .. . . . . . .. . . . . . .
. . ... . .. 3
. . . .. . . .. . . . . . .. .. . . . . . . . . . . . . .. . . .. . . . . . .. . . . . . .. . . . . . .. . . . . . . . . .. . . ...4
Results in Brief
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 C
Background
.. . . .. . : 2
Findings and Aecommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . .12
Finding 1 Causes of NextBank ' s Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Finding 2 OCC's Supervision of NextBank . . . . . . . . . . . . . . . . . . _ . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . .2 2
- Finding 3 Other Regulatory Matters .... . . . ... . ... . .. .
: : ...: : . .. . ... . .. . ._ . . .. . . . . . .. .33
.
:
Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
- . . . . . ..
.
. . .. . ... . ... .. . .. . . .. . ... . 36
Appendice s
Objectives , Scope , and Methodology . .... ... . .. . ... .... . .. . . . . . .. .. . . . . . . .4C
Appendix 1 :
Chronology of Significant Events .... : . .. . .. . .. . . . ....: . . .. . . .... .. . ... . . .43
Appendix 2 :
. .. . .. ... ... . . . . . . . . .. ......,_. . ... . .. . . ..... . 47 .
Glossary of Terms
Appendix 3 :
.
s . . ..
. . ... ...
.. .. . .. . ... . . . . . . . . . ... .. . . .. . .... . . . . .. ... .. . . . . . ....49
Appendix 4 : , Management Comment
is
Repo rt ... . . . . . ...... . . . . . .... .. . .. .. .. .. . .. . . ....50
:
Major
Contributors
To
Th
Appendix 5
.. . . . . . .. . .6~ .
.
.
.
.
..
....
.. .. ... .. .. . .. . . ..... . .. . . . ... ... . .
:
Report
Distribution
Appendix 6
Cha rt s and Tables
.. .
Chart No . 1 : Total Man qed &ssets September 30, 1999- December 31, 2001 . . ._ 13f
Table No . 3• : , NextBank artd NextCard Total Operating Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . I8
Table No . 2 A t.ount andUature of Required Account ing Adjustments . . .. . ... . .. . . .. ... -.-1 9
Table Ncr. .
.NC Exarnination issues and Enforcement Actions ... . ... . .. . .. .... . ...... .... 23
tBank ' s Operating Expenses Vs . Total Managed Assets .. . .. . . .. . .. ....27'
Chart No-. rs
. . ......... ..... . . . . ... .. 29
Table No .'. ;.NCrs. Board Resolution October 26, 2000 . .. . . ;
Abbreviation s
ALLL
Allowance for Loan and Lease Losses
CEBA
- Competitive Equality Banking Act of 1987
DRR 'Division of Resolutions and Receiverships ,
Material Loss Review of NextBank , NA IO1G-03 -024) P.g. 1-
i
I
Contents - - ;: . Abbreviations ( can't)
.y~• •.
r
6-`4 .~... s,`' Z _ '_. _•F ^ar .R~1f ["
~+ ~i _~rte•
i3
"•~'•• ' ~ ~'"- _~ k
:.
.:: .~• ''?"f: •
Eic
FAS
A
FDIA ~- i
FDIC aiic r ~ or~iac~ti`t ' s
NCB ~+ ~; .` • _.=: : _r :{' .~-y . r
re Cy `:
a b T ~pller ,tfie
©CCf - ~T
PC A
_SEC =-~scuritracharige Cocxi c~sior~ , " ,
Material Loss Review of NextB .ank, NA ( OIG -0 3-O24)
Page 2
I
Audi t
OIG
Report
The Department of the Treasury
Office of Inspector General
November 26, 200 2
John D . Hawke, Jr .
Comptroller
Office of The Comptroller of the Currenc y
As mandated under section 38(k) of the Federal Deposit Insurance
Act ( FDIA), we reviewed the failure of NextBank, National
Association, of Phoenix, Arizona (NextBank) . O n
February 07, 2002, the Office of the Comptroller of the Currency
(OCC) closed NextBank upon determining that unsafe and unsound
practices had substantially dissipated assets and that insolvency
was imminent without Federal assistance . NextBank's failure is
estimated to cost the Federal Deposit Insurance Corporation (FDIC)
between $300 and $350 million, making it the most costly failure
in 2002 .
The FDIA mandated review primarily requires us to ( 1) ascertain
the cause(s) of NextBank's failure ; (2) assess OCC's supervision of
NextBank ; and (3) where applicable, recommend how such failures
might be avoided in the future . We conducted the detailed audit
work at OCC Headquarters in Washington, D .C ., and the OCC
Western District office in San Francisco, California . We also met
with FDIC's Division of Supervision supervisory officials in
Washington, D .C ., and their regional office in San Francisco,
California . We reviewed OCC and FDIC supervisory files and
interviewed supervisory officials, attorneys, and examiners involved
in the examination, enforcement, and or receivership processes .
We also met with officials from FDIC's Division of Resolutions and
Receiverships (DRR) and the Division of Finance (DOE) personnel in
Dallas, Texas ; DOF personnel at NextCard, Inc . headquarters, the
parent company of NextBank in San Francisco, California . A
detailed discussion of the review objectives, scope, and
methodology is provided in Appendix 1 .
Material Loss Review of NextUank , NA (0IG- 43-024 1
Page 3
Results in Brief
In less than two and a half years, NextBank opened as OCC's first
Internet-only credit card bank, grew six-fold from $300 million to
over $2 billion in managed assets, never turned a profit, and failed .
Based on an unproven technology-based business strategy,
NextBank's initial capitalization seemingly arose from the
widespread dot-corn optimism that prevailed at the time .
NextBank's principal owners had just previously operated a simila r
Internet-based business venture that had also lacked earnings .
With a national bank charter, NextBank was able to pursue this
Internet-only business strategy, leveraging with Federally insured
deposits .
Chartered in September 1999, NextBank operated under the
provisions of the Competitive Equality Banking Act of 1987
(CEBA) .' As such, NextBank's product line was limited to credit
cards and it could not diversify through commercial loans .
NextBank's funding was also restricted to $100, 000 or greater
time deposits ; it was prohibited from obtaining less costly and less
volatile transaction demand accounts (e .g ., checking), and deposits
could only be accepted from a single office . NextBank effectively
served as a shell bank gathering deposits and booking the credit
card receivables which had actually been marketed, screened,
originated, and securitized by its sole owner and parent company,
NextCard, Inc (N CI ), of San Francisco, California .
Years prior to opening NextBank, the principals of NO had
developed propriety software that evaluated credit card applicants
over the Internet. Rather than its own bank, NCI initially applied
this technology through a nonaffiliated bank . Under that
arrangement, NCI marketed and screened credit card applicants
through the Internet, while the unaffiliated bank funded, originated,
and booked the resulting credit card receivables with each sharing
the associated proceeds . Although the strategy seemed to hold
promise as an effective financial service technology application,
NCI experienced consecutively increasing operating losses ove r
2 years prior to opening NextBank, totaling more than $47 million .
' 12 U .s_C .I1841It1(2UFb .
Material Loss Review of NextBank , NA (O1G- 03- 0 24) Page 4
Nevertheless, NCI raised over $299 million through two public
offerings in 1999 . Discontinuing the relationship with the
unaffiliated bank, NCI channeled most of the proceeds from the
public offerings to capitalize NextBank .
NextBank commenced operations in September 1999' and through
its Internet-based platform quickly grew to over $900 million in
assets in two years . The bank's actual growth was far larger than
that reflected by its balance sheet . NextBank securitized3 abou t
$ 1 .4 billion in card receivables and retained the servicing ti-e .,
managed) for over $2 billion in credit cards .
As with other technology-based companies at the time, NCI's stock
valuation reflected optimism rather than profitability . In what may
have been an attempt to maintain those exuberant valuations, NCI
deviated from its business plan as originally conveyed to QCC in
1998 . Asset growth more than tripled over plan, and NextBank's
targeted customer base shifted from prime to subprime borrowers .'
Rather than profitability, NextBank's growth into subprime credits
resulted in increasing annual losses . In just over 2 years of
operation, NextBank incurred an operating loss exceedin g
$108 million on over $2 billion in managed assets, and fell three
regulatory capital levels depleting capital by more than $96 million .
FDIC estimates NextBank's failure will cost between $300 and
$350 million .
Causes Of NextBank's Failur e
NextBank's failure can be attributed primarily to improperly
managed rapid growth that led to unacceptable high levels of credit
risk, losses, and operational problems . Supervisory files repeatedly
note that NextBank lacked the systems, controls, and expertise to
properly support its excessive growth in a safe and sound manner .
The challenges and risks associated with being an Internet-only
bank were magnified by the shift from the initial plan of prim e
2 Prior to Ncrs de novo application, there had been one other application with a business plan that entai€ed delivering bankin g
products and services by eIeCtronic means .
3 Securitization essentially entailed selling the bank's credit card receivables to investors through a third party which effectively
removed the loans off the bank 's balance sheet .
A 5ubprime borrowers are generally defined as eKhibiting significantly higher default risk than traditional bank customers . Another
common description is a borrower with a tarnished credit history ,
Material Loss Review of NextBank, NA (OIG-03-024) Page 5
1
lending to subprime borrowers ultimately accounting for more than
40 percent of total managed assets by mid-year 2001 . NextBank's
Internet-based technology also did not effectively control th e
associated credit risk . Indeed, some card applicants received initial
approval within 30 seconds of submitting an online application .
According to an OCC examiner, there was limited, if any,
verification of the on-line submitted information .
Even the credit risk reduction technique of securitization was
partially negated . Although not required under the terms of the
securitization agreement, NextBank would replace previously sold
credit cards that had defaulted with performing credit card
receivables to maintain the market confidence needed to sustain a
securitization program .
The severity of NextBank's [ending problems was also partly
obscured by deficient accounting practices . Contrary to standards,
NextBank fbllowed certain accounting treatments which effectively
served to understate operating losses by deferring the recognition
and reporting of (1) credit losses exceeding $12 million, (2) needed
loan loss provisioning expenses of about $13 million, and (3 )
$35 million in expenses that had been improperly capitalized .
NextBank's restricted funding to high cost volatile deposits not
only pressured interest margins, but also exposed the bank to a
heightened liquidity squeeze to meet depositors' demands . By the
end of the second year of operation, NextBank failed to maintain or
augment regulatory capital commensurate with its increased risks,
or with that needed to operate as a going concern .
OCC's Supervision of NextBan k
OCC conducted two full scope examinations over the life of the
bank . ©CC was quick to close NextBank once examiners
determined the severity of the bank's credit risk problems in the
latter part of 2001 . In fact, ©CC closed the bank before it became
"critically undercapitalized," doing so when it became apparent that
there were unrealistic prospects of returning to an "adequately
capitalized" level without Federal assistance . Nevertheless, we
believe there were aspects of OCC's examination and enforcement
procedures that warrant closer review and assessment given the
rapidity of NextBank's uncontrolled growth and failure .
Material Loss Review of NextBank, NA (OIG-03-024) Paige 6
For the bank's first full scope examination in 2000, the examinerin-charge {ElC) initially planned for what appeared to be a
comprehensive examination based on OCC's prior limited/targeted
site visit shortly after NextBank had opened . However, the actual
examination ended up less than planned, and the EIC was only able
to focus on the lack of documented controls and risk management
systems, and whether the bank had adhered to its original business
plan . Little, if any, in depth portfolio analysis was completed ; the
actual impact of the absence of controls and management systems
was not assessed ; and the bank's true financial condition as a
result of its rapid growth into subprime lending was not
determined .
The less-than-desired examination coverage in 2000 was due to
resource constraints in terms of budgeted examination hours, the
number of examiners, and the needed specialized experience and
knowledge of the credit card business and NextBank's technology
based platform . As a result, we believe the examination results
understated the bank's true risk profile and operating problems .
Consequently, OCC's enforcement response through a Board
Resolution did not appear sufficiently forceful to reasonably effect
corrective action . Further, the Board Resolution was based on a
questionable presumption that NO could provide needed capital
support .
A year later, the second full scope examination initially experienced
similar resource constraints . Again, examination coverage was less
than needed, but signs of portfolio deterioration had becom e
pronounced . Asset growth accelerated even faster than before
with only marginal management system improvements and doubts
arose as to the accuracy of the bank's financial records and
supporting management information systems . Indeed, before the
examination was completed, supervision of NextBank was turned
over to OCC's Special Supervision and Fraud Division in
Washington, D .C . in July 2001 .
Shortly thereafter, the examination recommenced but this time
with an expanded team including examiners with specialized skills
in credit card lending . The expanded second phase of the
examination in 2001 ultimately revealed NextBank's deteriorating
financial condition and portfolio, quantified the understated losse s
Material Loss Review of NextBank , NA (OIG-03-024) Page 7
I
due to deficient accounting practices, and effected the restrictions
and mandatory enforcement provisions of Prompt Corrective
Action .5 OCC also issued a Temporary Cease & Desist order, but
it's unclear how effective these latter enforcement actions served
to minimize FDIC's losses in that NextBank was closed 3 months
later in February 2002 .
Other Regulatory Matters
Prior to any OCC supervisory examination or enforcement actions,
we believe the circumstances and conditions under which
NextBank obtained its operating charter point to a potential
vulnerable regulatory area warranting management review,
Initially, NCI filed an application with OCC for a new charter in
December 1998 . FDIC raised concerns over approving Federal
Deposit Insurance for the new charter, which would have
prevented final approval of the charter . FDIC's concerns centered
on the stock options accruing to NCI owners and whether the
options would be in NextBank's best interest or its long term
viability . In May 1999, OCC conditionally approved the application
and included both pre-opening and on-going conditions intended to
ensure NextBank would operate in a safe and sound manner.
NCI then, however, pursued a different approach to chartering
NextBank . Rather than operate under a new bank charter, NO
instead filed a separate change-in-control application in August
1999 to acquire a dormant existing national bank charter . The
targeted charter would have existing FDIC deposit insurance
coverage and OCC does not as a practice precondition change-incontrol decisions . We believe, however, preconditions could have
possibly allowed OCC to more effectively control NextBank's
growth and operations early on rather than after its risk exposures
had reached critical and costly proportions . For example,
preconditions, in addition to those already set against the de novo
application, as to how NextBank would control and support its
projected growth might have helped OCC examiners assess and
prioritize NextBank's risks in response to the resource constraints
during the first full scope examination in 2000 .
S 12 U.S .C 1 1831 43 te ),{f1,fnl .
Material Loss Review of NextBank , NA IOIG- 03 .024? Page a
Finally, as a CEBA charted bank, NextBank's parent, NCI, was
exempt from Federal oversight by the Federal Reserve as normally
provided under the Bank Holding Company Act . NCI was licensed
in California, but had never been subject to state examinations or
oversight . While the OCC had examination authority over NCI as
an affiliate and third party service provider of NextBank, OCC
examination coverage of NC1 was limited to the transactions and
operations that directly related to the nationally chartered
NextBank . Beyond the legal organizational distinctions between
the two entities, NCI and NextBank were substantively the same
organization with dual senior managers and managing directors,
and NCI clearly controlled NextBank's financial resources .
However, OCC examinations did not cover the specific operations
of NCI or its financial records .
While possibly a unique situation, we believe this type of
organizational structure points to a potential supervisory gap
between OCC and a functional regulator . Of concern is when that
supervisory gap exists over the non-supervised parent company
whose financial condition and operations may adversely affect a
national bank . For example, OCC examiners were not aware of a
loan NC[ made in 2000 to a senior manager who had held dual
positions with NCI and NextBank . Months after NextBank failed in
2002, the loan and interest had stilt not been repaid . Although the
associated amount was not material (under $200,000), we are
reminded that one of NCI's primary source of funds was NextBank .
Moreover, OCC had always viewed NCI as a source of capital
support for NextBank .
Recommendation s
The report contains six recommendations aimed at enhancing
certain regulatory matters dealing with credit card banks,
refinements to certain examination and enforcement processes, a
potential PCA violation, change-in-control applications, and
oversight of unsupervised national bank parent companies .
©CC Response and ©IG Comment s
In its November 25, 2002 written response to the OIG's draft
report, OCC concurred with the reported findings and agreed tha t
Material Loss Review of NextBank , NA (OIG- 03-024)
Page 9
the recommendations, when implemented, may be helpful to
avoiding similar situations in the future . Over the next few weeks,
OCC plans to formulate action plans detailing the steps they will
take to implement the recommendations . The actions will be
formally reported and monitored through the Department's Joint
Audit Management Enterprise System .
We believe OCC's planned actions are responsive to the intent of
the recommendations . The OIG will also continue to monitor
OCC's progress in addressing the reported findings and
recommendations . The full text of OCC's response is included in
Appendix 4 .
Background
In 1996, NCI was incorporated in California and began offering
Internet-based consumer financial services . NCI had developed
proprietary Internet-based credit card application and underwriting
technology . NCI sought new customers only through Internet
advertisements and e-mail solicitations rather than the mass
mailings used by conventional credit card banks at the time . NCI's
Internet-based card system included accepting information
submitted by an applicant and applying both credit bureau
scorecards and discrete credit-specific criteria . The applicant could
receive preliminary approval or disapproval within 30 seconds .
NCI initially applied its Internet-based technology through a
partnership with a nonaffiliated bank . NCI solicited and screened
the credit card applications over the Internet, whereas the
nonaffiliated bank funded and originated the credit card receivables
from NCI's website . In return, NC! collected origination and
servicing fees plus a percent of the profits . However, NCI never
achieved profitability with iricreasing operating losses totaling more
than $47 million . Despite the lack of earnings, NCI was still able to
complete two public stock offerings in 1999, raising ove r
$299 million in gross proceeds . Like other technology-based
companies at the time, NCI was viewed as an outstanding prospect
by investors .
Material Loss Review of NextBank , NA (OIG-03-024 )
P a g ee 10
I
Rather than limiting itself to the technology applications, NO
acquired a dormant national bank charter in September 1 999 . The
acquisition enabled NO to fund its own credit card operations and
retain the credit card receivables . NCI discontinued the business
arrangement with the nonaffiliated bank, and channeled most of
the proceeds from the 1999 public offerings to capitalize the
acquired charter . The bank was named NextBank . National
Association (NextBank), becoming OCC's first charted Internet-only
credit card bank .
NextBank's charter was also subject to the provisions of CEBA .
Under CEBA, Nex€Bank's product line was limited to credit cards,
and it could not diversify through commercial loans . Its funding
was also limited to large deposits in amounts of no less than
$100,000, and it could not gather less costly or volatile transaction
deposits such as checking accounts . Although gathering deposits
was also restricted to a single office, NextBank's Internet platform
allowed it to effectively market and obtain deposits on a nationwide basis .
Aside from the legal organizational distinctions between the parent
company and the banking subsidiary, NCI and NextBank were
substantively the same entity . NCI employees staffed most of
NextBank's key operations and most of those operations were
covered under a fee based service agreement with NCI . NCI, in
turn, contracted some of the functions with its subsidiary or
another third party service provider . Key operations provided by
NCI included deposit gathering, card solicitations, screening, and
originations, most of which were performed in California . NCI also
maintained NextBank's financial records, support systems, and
website . As a result, NCI's sole source of income was NextBank
and most of NCI's operating cost was related to supporting
Next6ank's operations . In terms of key management decisions,
many of the senior managers and directors held dual positions at
both entities . From 1999 through 2001, NextBank paid NCI over
$173 million under the service agreement .
NextBartk Grew Rapidl y
Through its Internet-based platform, NextBank grew rapidly from
about $300 million in assets in September 1999 to ove r
Material Loss Review of NextBank, NA (OlG-03-024) Page II
$900 million in September 2001 . Besides the Internet technology .
other avenues facilitating rapid growth included balance transfers
(assuming an applicant's outstanding card debt balancels)) ,
accepting greater number of applicants with a higher risk of default
(subprime borrowers), and increasing cardholders' credit limit .
NextBank's rapid growth was far greater than reflected by its
balance sheet . In addition to the booked assets, the bank had sold
over $1 .4 billion in credit card receivables for securitization .
Besides reducing the credit risk, the proceeds from the
securitizations also enabled NextBank to fund growth . Indeed,
securitizations accounted for as much as 58 percent of total
funding by January 2002 .
NextRank's growth never reached the critical mass bank
management believed was needed to achieve profitability . Instead,
the rapid growth only resulted in operating losses totaling over
$108 million in just over two years .
The recognition of losses was also delayed due to deficient
accounting practices . However, by the fourth quarter of 2001,
examiners identified NextBank's true unsafe financial condition due
to its rapid growth, subprime loans, and the adverse effect of
providing support on loans previously sold through securitizations .
NextBank's regulatory capital fell sharply in just a few months,
from "well capitalized" to "significantly undercapitalized" by
October 2001 . As of October 31, 2002, NextBank's failure is
expected to cost the FDIC between $300 and $350 million, making
it the largest failure of the year, and NexiBank may well take on
the distinction as one of the quickest bank failures in decades .
Findings and Recommendations
Finding 1 Causes of NextBank's Failur e
NextBank's failure can primarily be attributed to rapid growth that
was not properly managed . The accompanying credit risks were
magnified with much of that growth involving subprime credits .
Operationally, NextBank faced not only the many challenges of
Internet banking, but also the added risks of being an Internet-onl y
Material Loss Review of NextBank , NA (©IG-03 -024)
.
. Page 12
bank . Under the operating restrictions of its CEBA charter,
NextBank was not able to mitigate credit risks through product
diversification or avoid the margin pressures given its high cost and
volatile funding, Indeed, profitability through NextBank's Internetbased business model was seemingly dependent on exceedingly
high asset volume . NextBank pursued this strategy but did not
have the systems and controls needed to support growth in a safe
and sound manner . As assets grew so did the associated credit
risks, losses and operational problems, followed by severe capital
depletion and NextBank's failure .
Rapid Growth In Subprime Loan s
NextBank's business strategy depended on asset growth to achieve
profitability . In 1999, management projected that more tha n
$800 million in total assets would be needed to break even, and
this growth was initially targeted at low risk prime borrowers .
NextBank grew its managed assets by more than six-fold in just
over 2 years as shown in Chart 1 below .
Chart 1
Total Managed Assets
September 30, 1999 -- December 31, 200 1
2,500.000
2.000,000
r
1 .500.000
1,000.000
S
! 500 .000
i
IF
a
9199 3100 9100
3 101 910 1
0 On-Book Assets ■ Trust Held Asset s
Source : Call Report s
Material Loss Review of NextBank, NA (OIG-03-024)
Page 13
El
As previously shown, by March 2000 managed assets included
both credit card receivables retained by NextBank (henceforth
referred to as on-book loansl plus card receivables sold for
securitization (henceforth referred to as trust-held loans)' . where
the bank retained the servicing . NextBank earned a fee by
servicing the sold assets . Securitizing credit card receivables
facilitated NextBank's growth . Total managed assets peaked to
over $2 .17 billion by September 2001 . NextBank's growth was
rapid and greatly exceeded the initial growth projections conveyed
to OCC . For example, planned growth was to reach $597 million,
but actual was $1 .5 billion in December 2000, and planned growth
was to reach $1 .2 billion, but actual exceeded $2 billion in
December 2001 .
Besides asset securitizations, excessive growth was also achieved
by increasing the origination of subprime loans . One industry and
regulatory accepted measure used in defining subprime borrowers
is the "FlCO score ."' From September 1999 to December 2001,
the average FICO score for the combined managed loan portfolio
fell from 704 to 655 . The regulatory benchmark for subprime is
660 . In July 2001, 72 percent of the Bank's on-book loans, and
38 percent of the trust held loans had FICO scores below 660 .
Not only had total credit risk increased, but NextBank had retained
the brunt of the increased credit risk associated with subprime
borrowers . NextBank's credit risk exposure grew worse as the
average FICO score for on-book loans continued to fall to 526 by
December 2001 .
While FiCO scores only reflect the risk of default, NextBank's
actual delinquency and default rates illustrate the adverse impact
from the subprime loans . More than 19 percent of the on-book
loans, and more than 9 percent of the trust-held loans were at least
30 days past due as of July 2001 . The annualized charge-off rate
at the time was more than 22 percent and 8 percent, respectively .
The examination files reflected a clear correlation between FICO
scores and charge-off rates, with loans with the lowest FIC O
a Typically, when a bank securitizes loans . the assets are held by a trust on behalf of the investors .
FICO score refers to a test developed by Fair, Isaac, and Company , which is widely used to evaluate the credit worthiness of
borrowers . Industry guidance published by the Federal Financial Institutions Examination Council in January 2001 defines a FICO
score of less than 660 as subprtme .
Material Loss Review of NextBank, NA (OIG-03-024) Page 14
scores having the highest charge-off rates . NextBank ' s cumulative
credit losses exceeded $41 million by December 31, 2001 .
Besides increased credit risk associated with growth , there were
also signs of higher credit risk seemingly unique to the Internet
platform . Examination files noted that Internet applicants were
much more likely to be c redit seekers who were beginning to
experience financial problems that had not yet been reflected in
their credit bureau reports . As a result of this informational lag,
Internet applicants resulted in an observed phenomenon known as
adverse selection . That is to say for any given FICO score ;,
applicants obtained over the Internet tended to have higher default
rates than applicants through traditional channels-
Increased Liquidity_Ris k
Due to the operating limitations of CEBA, NextBank faced high
liquidity risk .' NextBank funding was l imited to deposits of
$100,000 or more . Deposits at this high level generally command
not on l y above market rates , but also attract " rate chasers" who
are prone to moving their deposits to any bank offering higher
rates . Under CEBA, NextBank could not accept lower cost
demand deposits such as checking accounts or less volatile
deposits of under $100 ,000 . The liquidity risk associated with
these large dollar deposits heightened due to regulatory restrictions
imposed after NextBank ' s regulatory capital levels had fal l en in the
third quarter of 2001 . A severe liquidity crisis loomed based on
projections of net deposit outflows for the subsequent quarters
with high prospects of not. being able to meet depositors' demands ,
Ineffective Risk Managemen t
If properly managed, rapid growth and subprime lending does not
necessarily subject a bank to undue risk . However, the supervisory
files repeatedly indicated that Next8ank had not established an
effective risk management program needed to support these
activities in a safe and sound manner . The bank lacked adequate
management information systems, risk analysis procedures an d
a Liquidity risk is the risk to earnings or capital arising from a bank't inability to meet its obligations when they come due without
incurring unacceptable Fosses .
Material Loss Review of NextBank, NA (OIG-03-024} Page 15
skills, and risk measurement capabilities . Even fundamental risk
management planning was deficient .
According to examiners, the bank's management information
systems could not produce the information needed to measure and
monitor the bank's activities . For example, in mid-2001 the bank
increased the credit limits of existing customers by an aggregate of
about $ 250 million, without adequate management information
systems . The bank's existing system could not provide
management the information needed to determine the impact of
the credit limit increases on delinquency and default rates . The
reports generated were generally done on an ad hoc basis, rather
than regularly scheduled basis . As such the bank was less likely to
identify developing problems on a timely periodic basis through
regularly scheduled reports .
NextBank's management systems also did not produce accurate or
complete information . Examiners found that certain risk
management reports did not reconcile to the general ledger, and
portfolio data did not differentiate between the trust-held and onbook loan performance . The latter prevented management from
routinely tracking or analyzing the two portfolios separately .
Consequently, the deteriorating condition of the on-booked loans
were obscured by the generally better performing trust-held loans .
This situation would eventually have significantly adverse effects
on the bank .
Examination records also revealed that bank management .
implemented new initiatives without adequate testing,
measurement, and analysis . For example, in mid-2001 the bank
implemented a credit card repricing plan to increase interest rates
for cardholders whose FICO score had fallen 75 points after the
bank had originally approved the card applicant . It observed the
performance of a test population of accounts for only 21 days
before deciding to expand the repricing plan to the entire loan
portfolio . Normal industry practice would be to base such
decisions on a minimum test period of six months . The repricing
plan affected $350 million in receivables . The initiative, however,
adversely impacted NextBank . In response to the increased rates,
the lower risk cardholders left the bank and the higher risk
cardholders experienced higher delinquencies .
Material Loss Review of NextSank , NA (OIG-03-024}
Page 16
I
Relaxed Underwriting Standard s
May 2000 loan portfolio data indicated that the bank experienced
substantial levels of downward FICO drift as existing cardholders'
updated FICO scores fell after being approved for a credit card . For
example, the average portfolio FICO score at September 1999 was
704 and 675 for May . In May 2000, more than 18 percent of the
managed loan portfolio had updated (added for emphasis) FICO
scores below 650 . However, only 3 percent of these same loans
had FICO scores this low at origination .' FICO drift contributed to
an overall decline of the managed portfolio . As of May 31, 200033 percent of the managed portfolio was below 660, which is
below the regulatory definition of subprime . Rather than tightening
underwriting in response to the increased credit risk, NextBank
management relaxed the underwriting standards . From January
2001 to July 2001, the applicant approval rate remained constant
but approvals comprised of an increasing number of applicants with
even lower FICO scores from 620 to 659 .
Operational Problem s
Compounding the risk of improperly managed growth and subprime
lending, NextBank's Internet-based platform suffered from two
other problems that contributed to its failure : high operating cost
and deficient accounting practicesHigh Operating Costs
NextBank's Call Reports reflected increasing operating costs
averaging $14 million per quarter in 2000, growing to an average
of $37 million in 2001 . Operating costs consisted mostly of the
fee service agreement with the parent NCI, and far exceeded what
NextBank had projected in its original business plan . Moreover,
there were indications that NextBank's operating costs were
actually higher than reported, which would have the effect of
understating the bank's losses .
The bank's reported operating costs consisted primarily of
payments to NCI under a fee for service agreement . NCI provide d
9 Both percentages are based on the receivable be ance owed ,
Material Loss Review of NextBank , NA (OIG-03-0241
. Page 17
most of the bank staffing, facilities, technology, and equipment .
NCI also subcontracted portions of the functions to various third
party service providers, such as collections and information
technology . NextBank's payments to NCI under the service
agreement exceeded 75 percent of NextBank's total operating
expenses . Also, the bank's actual operating expenses far
exceeded the levels projected in NCI's original charter application .
For example, actual operating expenses exceeded planned for 2001
by more than 2 .3 times, i .e ., $148 million vs . $62 million .
As noted previously, bank operations were largely conducted by
NCI and NCI's operating costs relate mainly to services provided to
NextBank . Based on NCI's Securities and Exchange Commission
(SEC) 10-K reports, there were indications that NextBank's true
operating expenses may have been understated . As Table 1
shows, NCI operating expenses significantly exceeded that of the
bank .
Table 1
NextCard and NextBan k
Total Operating Costs
($000 )
2000 $146,249 $59,057 $87,192
2001
175,055 148,024 27,031
Total $321,304 $207,081 $114,223
Source : CaEI Reports and SEC Forms O- Q
The difference column suggests that NextBank may have
understated by more than double its operating expenses in 2000,
in turn, understating its operating losses . In so doing, NextBank
may have delayed regulatory attention from the magnitude of
actual losses, as well as NextBank's longer-term prospects .
Deficient Accounting Practice s
In addition to the aforementioned operating costs, NextBank also
followed certain accounting practices that further served to
understate its losses, mask its true financial condition, and possibl y
Material Loss Review of NextBank , NA (01G-03-024)
Page 18
delayed regulatory triggers that would have called for large capital
augmentation .
Table 2 shows the accounting adjustments that OCC required
which totaled over $ 88 million .
Table 2
Amount and Nature of Required Accounting Adjustment s
Write down of deferred loan acquisition costs
Write down of seller's interest from securitizations
$35,71 8
21,89 9
Increase loan loss provision expense
13,197
Reclassification of fraud losses
12,04 7
Establish Reserve for Uncollectible interest & Fees
Total required adjustments
5,598
$88,459
Source : QCC examination file s
Deferred Loan Acquisition Cost s
Fees paid for accounts opened by the parent NCI were incorrectly
recorded as an asset ideferred loan acquisition costs), to be
amortized over a 12-month period . According to Financial
Accounting Standards (FAS) No . 91, loan acquisition costs may be
capitalized only if paid to an independent third party . Since NCI
was not an independent third party, these costs should have been
expensed . OCC required the bank to write down capital by over
$35 million for the associated fees paid to NCI throug h
September 30, 2001 .
Incorrect Valuation Of Seller's Interests
The terms of NextBank's securitization trust agreement required
the bank to retain a seller's interest in the trust . NextBank
accounted for this as a receivable and recorded it at par . Because
the seller's interest was "certificated," the bank should have
recorded the seller's interest as a security rather than a receivable .
CCC required the bank to reclassify the asset as a security as wel l
Material Loss Review of NextBank , NA (OIG-03-024) Page 19
as write down its recorded value by about $22 million to reflect
current fair market value, in accordance with FAS 115 .
Inadequate Loan Loss Provisioning
NextBank's basis for provisioning the Allowance for Loan and
Lease Losses (ALLL} account provided for 9 months of losses .
0CC determined that a more appropriate period would have been
12 months given the bank's deficient underwriting, account
management , and collections practices . The additional provision
required by ©CC amounted to $13 . 2 million .
Establish Reserve for Accrued Interest and Fee s
Given the subprime nature of the assets held by NextBank, the
collectibility of some portion of the associated accrued interest and
fees were likely in doubt . Accordingly, 0CC required the bank to
establish a $5 .6 million reserve for uncollectible interest and fees .
Though required by FAS 5, the bank had not previously provisioned
for this contingency .
Misclassification of Fraud Losse s
From the first quarter of 2000 through the second quarter of 2001,
the bank accounted for certain types of losses as a fraud rather
than a credit foss . The basis for this accounting treatment did not
conform to industry practice, and examiners also noted several
operating inconsistencies that did not support this accounting
treatment . These inconsistencies included : the lack of associated
filing of Suspicious Activity Reports ; charging off the losses after
180 days instead of the 90 days to be in line with bank's fraud
policy ; and the lack of involvement by the Bank's Fraud
Department .
The required accounting reclassification totaled $12 million . The
affect of this incorrect accounting was twofold . By understating
the amount of credit losses, the ALLL was likely inaccurate (under
provisioned), and regulatory capital was deficient given how
NextBank responded to those "fraud losses" that were associated
with the trust-held loans . The tatter problem is discussed in further
detail below 'Implicit Recourse . '
Material Loss Review of NextBank , NA (OIG-03-024) Page 20
x
Im licit Recours e
As previously discussed, NextBank decreased its credit risk by
selling its loans for securitization . However, 0CC examiners
determined that the bank would replace certain sold loans that had
defaulted with its own performing loanst° . In so doing NextBank
effectively retained the credit risk . Although they were not
obligated to provide this backup support, it appears NextBank did
so to maintain market confidence in its assets for future
securitizations .
The terms of the securitization agreement provided for NextBank to
give backup support for losses arising from fraud but not normal
credit losses . As previously discussed NextBank had incorrectly
accounted for over $12 million in fraud losses . Aside from the
accounting adjustments, there were even larger implications for,
regulatory capital purposes for providing backup support on losses
improperly accounted as fraud losses .
Regulatory guidance over assets sales with recourse requires the
recognition of the retained credit risk for calculating capital
adequacy ." 000's Capital Steering Committee determined that
NextBank's had provided full implicit recourse on the securitized
receivables in light of the practice of replacing loans misclassified
as fraud losses . Accordingly, 0CC required the bank to include
$1 .2 billion in securitized assets in determining how much
regulatory capital would be needed to support the additional risk .
As a result, NextBank's risk-based capital ratio fell fro m
17 .02 percent to 5 .38 percent . In so doing, NextBank's regulatory
capital dropped three PCA capital levels to the "significantly
undercapitalized" category . NextBank was unable to restore capital
to sufficient levels, and many of the previously cited problems cast
further doubt that the bank could continue as a going concern .
7e Et was une€aar from the supervisory files whether Nexteank effected these replacements by reimbursing the trust or actually
exchanging loans.
It 12 CFR Fart 3 . Risk-Based Cepital iiegvirements--low Level Recourse .
Material Loss Review of Next8ank , NA (OIG-03- 0 24 )
Page 21
Finding 2 OCC's Supervision Of NextBan k
The rapidity of NextBank's growth and failure raises questions as
to the adequacy of supervision in terms of detecting problems and
responding with appropriate regulatory sanctions, We believe that
supervisory performance was mixed . Sanctions taken in late 2001
and early 2002 appeared timely and appropriate . But OCC early
examinations were partly hampered by resource constraints, which
appeared to have delayed the complete detection of NextBank's
actual risk profile, embedded asset problems, and unsafe banking
practices . Left without an effective enforcement action, NextBank
continued its uncontrolled growth to large and costly proportions .
Given NextBank's mere two and a half years of existence, it's
unclear how much of a difference earlier detection would have
made . However, NextBank clearly illustrates how quickly an
institution can accumulate large risk positions to the point that the
supervisory response can do little to avert a costly failure .
Examination History and Enforcement Action s
Table 3 summarizes the results of OCC's examinations and
enforcement actions . Also see Appendix 2 for a detailed
chronology of significant events regarding NextBank .
Material Loss Review of NextBank , NA (OIG-03-0241
. Page 22
Table 3
QCC Examination Issues and Enforcement Action s
CAMELS
Date
1216 ;99 2'222322
Ex;krninaiinn Type
Significant Safely and Soundness 'Supervisory Response /
I-Imited scope .
• Establish a strategic marketing • Non e
plan covering growt h
initial (60 day)
on-site
• Establish a formal and
comprehensive capital plan
• Enhance credit risk management
in three area s
• Strengthen Internal Audi t
function
• Establish a Vendor Management
progra m
• Establish a formal Strategic
Planning process
• Enhance liquidity ris k
management in four areas .
[
518!00
21222322
Full scope
l{
• Inadequate planning
methodology and capital
planning proces s
• Inadequate Credit Risk
• lOiOO Board Resolutio n
issue d
Managemen t
• High risk areas not audited
• Unfocused Vendor Managemen t
progra m
• Problems retaining and recruitin g
management personne l
• High credit risk and increasing
due to significant growth and
expansion in subprime lending .
• Severe deterioration of asset
quality .
$121101
8120/01
Preliminary
not rated
Full scope
Phase 1
• Examiners could not conclude on
the condition of the bank
• 7113101 Supervision turned
over to Washington, A.C .
Special Supervision Uni t
51545554
Full Scope
• Insufficient risk, audit, and
• 11101 PCA Directive issued
Expanded
Phase 2
control systems
• Inadequate independent
assessment of bank practices
• 2102 Temp C&D issue d
• 2102 Order of Investigatio n
• 2102 Bank Close d
and records
• Improper accounting practice s
• Incomplete SARs filin g
Source 0CC Reports of Examination & Supervisory Mae
4z The CAMELS system grades institutions on 6 factors : capital, asset quality, management . earnings . liquidity . and sensitivity to
risk . Performance is rated on a scale of t to 5 with 5 being the worst .
Material Loss Review of Nextfank, NA (OIG-03-0241 Page 23
Based on the supervisory record, we believe there were three major
areas that reflect mixed supervisory effectiveness . One, the large
dramatic drop of three CAMELS rating levels in a year's time raises
questions whether the earlier examination efforts had full y
assessed the bank's financial condition and the emerging problems .
Two, the persistent reporting of certain examiner concerns raises
questions as to the effectiveness of the enforcement response .
Three, the bank's continued phenomenal growth continued despite
the lack of adequate controls and systems .
NextBank's Examination s
About 60 days after NextBank opened, OCC conducted a limited
scope examination to : (7 ) assess the bank's condition and risk
profile and (2) gain an understanding of how management intended
to organize, manage, and grow the new bank . The scope was
limited given the short time the bank had been operating, and the
examination coverage reflected a review of policies and procedures
but not detailed testing or analysis- Nevertheless, examiners
pointed out several areas warranting management attention and
corrective action .
Five months later OCC commenced NextBank's first full scope
safety and soundness examination in May 2000 . The examination
scope memo reflects that the EIC had planned for comprehensive
coverage, including Information Technology, consumer compliance,
financial trends and credit risk management . However, the number
of requested hours, examiners, and experience needed were not
available due to higher priorities at other credit card banks at the
time . As a result, examiners were able to touch upon most areas
but available resources precluded in-depth analysis and testing . For
example, about 100 staff days for six examiners had been
requested to review asset quality . But only five examiners were
provided, two of which had no prior asset quality or credit card
experience . Roughly 6 0 days were spent on this aspect of the
examination .
Constraints aside, examiners found that the bank had done little to
address their concerns raised in the prior December limited review .
Moreover, signs of emerging problems were found, most notably
increasing credit risk as reflected by increasing charge-off rates ,
Material Loss Review of NextBank, NA (OIG-03-0241 Page 24
and the bank's planned expansion into subprime markets despite
insufficient progress in addressing prior examiner concerns . The
charge-off rates ranged from 9 to 12 percent on the loans that had
been transferred from NCI when NextBank originally opened .
Of note was that the loans had been underwritten and originated
under NCI's Internet-based platform for which current originations
were growing . Moreover, actual growth was greatly exceeding
original business plan projections . The bank had projected assets
would reach $139 million by December, but actual growth had
more than tripled at $468 million . As Table 3 previously showed .
the CAMELS ratings went unchanged from the prior targeted
examination with an overall composite rating of 2 .
The following year's full scope safety and soundness examination
experienced similar resource constraints . For the asset quality
review portion, about 200 staff days for eight examiners had been
requested . But only seven examiners were provided, five of which
lacked asset quality or credit card experience . And instead of 200
days, about 80 days were spent on this aspect of the examination .
Again, examiners found that bank management had done little to
address concerns raised in the 2000 examination even though the
board had formally resolved to address them . Credit risk and
losses were more pronounced with charge-offs now at 22 percent
on the on-book loans and 8 percent on the trust-held loans . Also,
the overall loan portfolio had clearly drifted from prime to subprime
borrowers as reflected by the increase in cardholders with FICO
scores under 660 . However, examiners could not precisely assess
the full impact of the observed problems and rapid growth, and
greater uncertainty arose as to the bank's true financial condition,
given signs of questionable accounting practices .
Supervision of NexiBank was then moved from the Western
District to the Special Supervision and Fraud Division in
Washington, D .C . in July 2001 . The second phase of the 2001
examination recommenced in August but this time included issue
area specialists from outside the district and no staff day .
constraints were imposed . By mid-September the gravity of the
problems had been assessed, many of the needed accounting
adjustments identified, and supervisory determinations (e .g .,
implicit recourse) that would result in the automatic triggering o f
Material Loss Review of NextBank , NA (OIG-03-0241 Page 25
the operating restrictions under Prompt Corrective Action (PCA)
implemented .
Areas Warranting Further Examiner Revie w
As discussed in Finding 1, two contributing factors to NextBank's
failure were its high operating costs and deficient accounting
practices . Aside from the possible resource constraints, we believe
less than sufficient examiner attention and review had been given
in the two areas .
NextBank's operating expenses were largely comprised of the fee
service agreement with NCI . Payments to NO accounted for over
75 percent of the bank's total operating expenses . Actua l
expenses far exceeded projected expenses under the business plan
by more than 2 times in 2001 . Expenses which totaled ove r
$222 million likely absorbed the roughly $194 million in capital
provided by NCI . From the first site visit in 1999, examiners
pointed out the need for a Vendor Management program to oversee
the performance of third party service providers . The same
concern was raised again in the 2000 examination .
Aside from pointing out the absence of a formal Vendor
Management program, examiners did little to assure that the fees
were accurate, reasonable, or appropriate, particularly in light of
the parent company relationship . The fees were not only large but
on a quarterly basis exhibited an unusual trend in that expenses did
not parallel the bank's growth as might be expected, and there was
an unexplained spike in the third quarter of 2001 as illustrated in
Chart 2 .
Material Loss Review of NextBank , NA (OIG-03-024) Page 26
Chart 2
NextBank's Operating Expenses Vs . Total Managed Asset s
- - - - - _ ._ . . . .
s ____
° 7
_-
25
20 v,
0
5
N
15
10
5 2
CL
5
X1 _
0--~
CD
46
r_
CD
C
0
CD
<[> cA A A O O O d d O
L`3 tD O O 0 O -+ -~
1
-~ ■~ -Quarterly Operating Expenses
4
Total Managed Assets
Source : Call Reports
Examiners could not recall conducting an extensive review of the
operating charges under the service agreement but suggested the
fees had been compared to industry standards, and reliance had
been placed on the external auditors to surface any problems .
We found no documentary evidence in the examination files
evidencing that the operating charges had been reviewed as to
compliance with the NCI's service agreement, accuracy or
reasonableness, or how the examiner had determined comparability
to industry standards . There were indications that examiners were
aware that NCI was in fact subsidizing NextBank`s charges, as
previously discussed in Finding 1 . We believe that by not fully
assessing the accuracy and appropriateness of the fee charges,
examiners in 2000 may not have been fully aware of the extent of
NextBank's actual operating losses, and thus true risk profile .
As discussed in Finding 1, OCC examiners identified roughly
$88 million in needed accounting adjustments, some of which
materially affected NextBank's capital . We found indications of
examiners' concerns in this area surfacing around January 2001 .
However, the concerns were presented as minor and dealing wit h
Material Loss Review of NextBank , NA (01G-03-024)
Page 27
I
only two of the five adjustments listed in Table 2 . It was not until
the second phase of the 2001 examination that the major
accounting issues were fully developed .
The 2000 examination scope memo provided for assessing
accounting and affiliate transactions . But, it appears from the
examination files and discussions with examiners that their focus
may have been limited to a general review of policies and
procedures, affiliate and intercompany transactions, and associated
controls . As to the bank's compliance with standard accounting
practices, we found no documentary support of any coverage of
the external auditors work as provided under OCC's Internal and
External Audits Comptroller's Handbook of July 2000 . For
example, we did not find documentation that the Audit Function
Questionnaire had been completed which would have provided the
basis for assessing whether additional examination coverage would
have been needed .
Examiners acknowledge that some of the questionable accounting
practices started in early 2000, but said the associated amounts
were likely too small to have been of concern at the time . We
suspect that some level of reliance may have also been placed on
the external auditors' work under NCI's consolidated financial
statements . We did not expand our work as to the reliability of the
external auditors' work given SEC's on-going investigation of NCI
at the time of this report .
Although we believe examiners could have expanded their
coverage over the service fee agreement and accounting practices
in 2000, it's unclear whether earlier detection by a year would
have materially impacted the supervisory response, the bank's
failure, or its cost to the FDIC . Again we are reminded how quickly
the bank grew and increased its overall risk profile ,
Enforcement Action s
To address the concerns identified in the 2000 examination, OCC
requested that the board officially commit through a resolution to
address the identified weaknesses . The enforcement action is
viewed as an informal action but of lesser severity than OCC
issuing other informal enforcement documents such as a
Material Loss Review of NextBank, NA {OIG-03-024 } page 28
commitment letter or memorandum of understanding . Certain
types of issued enforcement documents are subject to public
disclosure as a regulatory enforcement sanction, whereas a Board
Resolution is not . Table 4 shows the areas that OCC required the
institution to address .
Table 4
NCI Board Resolution
October 26, 2000
Tillieffame s
• Curtail growth of managed subprime receivables
originated to 5 percent .
• Maintain Total Risk Based Capital greater than 1 2
percent of risk weighted assets , and equity capita l
plus ALLL of at least 6 .5 percent of tota l
managed assets .
• Modify the 3-year strategic plan to provide fo r
reasonable growth rates , adequate capital and
adherence to the plan .
• Develop a Credit Risk Management progra m
25 day s
25 day s
60 day s
including limits on the degree of risk incurred ,
systems to measure and contro l risks , and skille d
employees managing the risks .
60 day s
• Develop monthly & quarterly risk managemen t
reports for management review .
60 day s
• Ensure the risk manager was independent of credi t
decision-making activities .
60 day s
• Develop a Marketing Plan to carry out the strategi c
plan .
• Develop a 3 - year Capital Plan, including a Capita l
Assurance Agreement between NextBank and
NCI .
• Enhance the Internal Audit program .
• Implement a Vendor Management progra m
governing outsourcing of banking functions
60 day s
60 day s
30 day s
30 day s
Sours : OCC Supm(tary MI S
We believe that the 2000 examination had established sufficient
basis for using a more forceful enforcement action than a Board
Resolution to effect corrective action . NextBank had no t
substantively addressed the concerns raised in the prior 1999 sit e
Material Loss Review of NextBank, NA (OIG-03-024) page 29
visit, such as a establishing a plan covering growth and vendor
management . Moreover, NextBank clearly exhibited a higher risk
profile given its accelerated growth above the original business
plan, its planned expansion into subprime credits, and the unproven
Internet platform for controlling credit risk as evidenced by the
9-12 percent charge-off rates of the older loans . In addition,
operating losses were not stabilizing and the bank's revised
projections indicated that -profitability could be achieved through
higher than planned growth . Given the absence of fundamental
bank risk management systems, we believe an appropriate
response would have been an issued enforcement document rather
than continually relying on bank management commitments .
Besides the type of enforcement action, there were also certain
aspects of the Board Resolution that seemingly could have been
enhanced, specifically those aimed at growth and capital coverage .
The Board Resolution only attempted to curb subprime growth with
a set limit beyond a capital limitation even though the bank lacked
systems and controls to support prime loan growth as evidenced
by the increasing charge-off rates of prime credits .
The requested capital support of 6 .5 percent to total managed
assets can be traced to the original charter application in 199$_
However, that capital level was in support of projected volume and
the type of business (i .e ., prime creditors) at the time . As
previously noted, those two basic assumptions materially changed
with actual growth more than doubling planned, and the shift from
prime to subprime credits .
Another aspect of the Board Resolution was a required capital
assurance agreement between the bank and NCI . The agreement
called for an assurance from NCI to provide additional capital if the
bank's capital ratios fell below certain regulatory thresholds .
Although it was reasonable to look to the parent and sole owner
for needed future capital support, NCI had demonstrated that any
capital support would not come from operations given its
consecutive years of net operating losses, even prior to owning
NextBank . NCI's March 31, 2000, 10-Q reported cumulative
operating losses continued to increase and now exceede d
$11 2 million since it began in the Internet credit card business .
Material Loss Review of NextBank , NA (OIG-03-024) Page 30
These increasing losses were dissipating NCI's financial base and
funds obtained from the 1999 public offerings .
The Board Resolution proved to be ineffective in getting the bank
to take corrective action . Most of the milestones were not met,
and there was also uncertainty arising as to the interpretation of a
key provision . Each month OCC was to monitor the bank' s
progress towards meeting the 5 percent subprime loan restriction .
However, the monthly reports filed by the bank were taken on face
value ; the examiner did not verify these reports . It was not until
the second phase examination in 2001, some 9 months later, that
examiners determined the reports had been inaccurate . Rather
than control subprime growth to 5 percent, actual subprime loans
were 34 percent for the quarter ending March 2001, an d
27 percent for the following quarter . Bank management attributed
this to a misunderstanding of the Board Resolution . OCC officials
acknowledge that the Board Resolution had been ineffective, and
pointed out that under the revised enforcement policy, PPM 53103, July 2001, Board resolutions are no longer available as an
informal action .
Prompt Corrective Actio n
Prompt Corrective Action (PCA) provides Federal banking regulators
an added enforcement toot to promptly address "undercapitalized"
banks and thrifts . PCA consists of a system of progressivel y
severe regulatory intervention that is triggered as an institution's
capital falls below prescribed levels . PCA does not replace or
preclude the use of other available enforcement tools (e .g ., cease
and desist orders) that address unsafe and unsound banking
practices before capital becomes impaired . PCA aims to minimize
losses to the FDIC by providing for a quick regulatory response to
troubled institutions .
When ©CC had determined in October 2001 that NextBank had
provided implicit recourse on the trust-held loans, the resultant
additional bank assets effectively dropped the bank's regulatory
capital level from "well capitalized" to "significantl y
undercapitalized ." At that point, NextBank was automatically
subject to the restrictions of PCA . Additional restrictions wer e
imposed by OCC in November 2001 through a PCA Directive
Material Loss Review of NextBank, NA (OIG-03-024) Page 31
containing 12 provisions . Some key provisions required NextBank
to : develop a capital restoration plan due in 45 days ; file amended
Call Reports ; restrict new credit card account originations to RCO
scores above 680 ; prevent dividend payments ; and restrict asset
growth, management fees, and brokered deposits .
By December 2001, NextBank advised OCC that it would not be
able to address its capital deficiency . In January 2002, NCI and
NextBank filed with the OCC an Asset Disposition Plan detailing
plans to liquidate the bank . Notwithstanding the attempts made
during numerous subsequent meetings to resolve the bank's
financial condition, OCC appointed FDIC as receiver o n
February 7, 2002 .
Brokered Deposit Restriction s
PCA restricts the use of brokered deposits and the rates paid on
deposits when regulatory capital falls below the "well capitalized"
category . These restrictions are intended to slow or reverse
growth, and thus risk, by limiting a troubled institution's funding
sources . For NextBank these restrictions were automatically
triggered on October 31, 2001 .
Call reports show a net outflow of about $56 million in deposits
from September 30, to December 31, 2001 . However, brokered
deposits increased roughly $135 million from $55 million to
$190 million during this timeframe . Because we were unable to
determine the actual dollar amounts of brokered deposits and bank
deposits on the day the PCA directive was issued, we spoke to an
OCC analyst about the apparent increase in brokered deposits .
The analyst opined that the apparent increase could have been due
to the bank's definitional interpretation as to what constituted a
brokered deposit. Prior to the deposit restriction, the bank had not
reported certain fiduciary deposits as brokered deposits . The
analyst believed that NextBank might have reclassified a portion of
their fiduciary deposits as brokered deposits for th e
December 2001 Call Report . We could not determine or estimate
how much of the $135 million in additional brokered deposits could
have been due to the reclassified fiduciary deposits versus ho w
Material Loss Review of NextBank , NA (OIG-03-0241 -
Page 32
I
much may have actually been due to the use of brokered deposits
contrary to the restriction .
PCA Effectivenes s
PCA's effectiveness in NextBank's situation is difficult to assess
given the short time period of about 85 days from the time the
PCA Directive was issued to the bank's closure . The implicit
notion that PCA provides prompt and progressively severe
enforcement action based on a bank's capital position appeared
irrelevant in NextBank's situation . By the time Nextbank's true
financial condition had been determined in the later part of 2001, it
had already accumulated critically, if not irreversible, large
proportions of risk . Coupled with the CEBA operating and funding
restrictions, the bank had few, if any, realistic options to survive
PCA . Rather than prompt enforcement action, NextBank's
situation points to a need to quantify uncontrolled growth so that
risk and not just capital levels triggers supervisory action .
Conventional enforcement actions had not been effective .
Finding 3 Other Regulatory Matter s
One of the mandated review objectives of a material loss review is
to bring to regulators' attention any issues which might assist in
avoiding bank failures in the future . Although not directly related
to the examination of NextBank, we believe the circumstances and
conditions under which NextBank obtained its operating charter
point to potentially vulnerable regulatory and supervisory areas
warranting OCC's review .
Potential Vulnerability in the Application Proces s
NCI initially applied to OCC for a new credit card bank charter in
December 1998 . NCI's application clearly disclosed the planned
Internet-based platform and delivery channel, its targeted prime
customer base, planned funding, and basic organizational structure .
In reviewing such applications, OCC considers (1) the organizers'
familiarity with national banking laws and regulations, (2)
competencies of the managers and directors, (3) capital adequacy
relative to projected volume and type of business activity, (4)
profitability prospects, and (51 the safety and soundness issues .
Material Loss Review of NextBank , NA (OIG-03-024)
Page 33
OCC's final approval of a bank charter also depends on the bank
obtaining FDIC deposit insurance . Although FDIC had reached
favorable determinations for most of the insurance considerations,
the FDIC March 1999 field investigation recommended that the
Washington FDIC office deny deposit insurance . The denial was
based on the factor "General Character of Management,"
specifically over the planned compensation to insiders . The FDIC
field investigative report concluded that the stock options accruing
to NCI owners did not appear to be in the best interest of Next8ank
or its long-term viability . Aside from the FDIC concerns, OCC
granted NCI "preliminary conditional approval" in May 1999 .
However, OCC's approval included 12 conditions, which
collectively were designed to better ensure that once opened,
NextBank would operate in a safe and sound manner .
NCI then, however, pursued a different approach to chartering
NextBank . Rather than operate under a new bank charter, NC1
instead filed a separate change-in-control application to acquire a
dormant existing national bank charter in August 1999 . In so
doing, the targeted charter would already have existing FDIC
deposit insurance coverage, and OCC does not as a practice
precondition change-in-control applications . NCI opened NextBank
under the change-in-control application in September 1999OCC's authority to precondition a change-in-control application
appears unclear and subject to interpretation . When we initially
asked OCC why NextBank's change-in-control decision had not
been subject to the same conditions as its prior new bank charter
application, we were told that OCC lacked clear legal authority to
do so . We brought to their attention the OCC Corporate Manual"
for chartering an Internet Bank, which specifically states, in part :
" . . .OCC may approve or conditionally approve any (emphasis
addedl filing after reviewing the application . . ." OCC officials
indicated that the manual reference applied only to new charters
and not a change-in-control application . Furthermore, OCC officials
were not certain if such preconditions would be legally enforceable
even though they were aware that the Federal Reserve
preconditioned change-in-control applications and believed such
preconditions were enforceable under 12 U .S .C § 1818 .
= ) The lovemet and the National Bank Charier, Cvmp[raFler's Corporate Manual, January 200 1
Material Loss Review of NextBank , NA l0IG-03-O241,
Page 34
We believe NextBank was, in substance, a new bank given the
dormant status of the acquired bank charter . Accordingly, we
believe preconditions were not only prudent but also could have
possibly allowed OCC to more effectively control NextBank's
growth and operations early on rather than after its risk exposures
had reached critical proportions . For example, one precondition
OCC had invoked under the new bank charter, which could have
been expanded, was a minimum 5 .5 percent capital to managed
assets ratio . Such a precondition seemed appropriate given
NextBank's unproven Internet-based technology, and the unknown
risks at the time of Internet banking, let alone being an Internetonly bank . NextBank was clearly not to be just another credit card
bank . Besides the added capital cushion, preconditions may have
also provided examiners an added basis to assess risk and prioritize
examination tasks during the first full scope examination in 2000 .
Parent Company Lacked Sufficient Regulatory Oversigh t
Finally, as a CEBA charted bank , NextBank ' s parent , NO, was
exempt from Federal oversight by the Federal Reserve under the
Bank Holding Company Act . NCI was licensed in California but had
not been subject to state examination or oversight . While the ©CC
had examination authority over NO as an a ffiliate and third party
service provider of NextBank , OCC examination coverage of NO
was limited to transactions and operations that directly related to
NextBank . Distinguished only by legally separate organizational
structures , NCI and NextBank were substantively the same
organization with dual senior managers and managing directors .
NCI also controlled NextBank ' s financial resources and operations,
the latter through a fee-based servicing agreement . In substance,
NextBank was a shell bank that booked insured $100 , 000 time
deposits and credit card receivables . But those assets,
transactions , and liabilities were essentially created by NCI , a NCI
operating subsidia ry , or a third party service provider contracted by
NCI . NCI ' s financial condition and operations clearly could impact
NextBank and its Federally insured depositors .
OCC examinations of NextBank did not cover NCI's specific
operations as the parent company or its financial records . In
effect, NCI was not subject to Federal oversight or sufficien t
Material Loss Review of NextBank, NA (OIG-03-024) Page 35
oversight by the state functional regulator, certainly not to the level
normally provided over an equivalent bank holding company .
While possibly a unique situation, we believe this type of
organizational structure points to a potential supervisory gap
between OCC and a functional regulator .'` Of concern is when
that supervisory gap falls over the parent company whose financial
condition and operations may adversely impact a national bank .
For example, OCC examiners were not aware of several personal
loans NCI made in year 2000 to certain employees, including a
senior manager that had held dual positions with NC! and
NextBank . According to NCI's 10-K filing, the manager's loan
included a stated interest rate and was secured by NCI stock and
stock options . Eight months after NextBank failed, the manager's
loan and accrued interest had still not been repaid and is currently
subject to a collections suit .
The amount of the manager's loan was not material (Le ., under
$200,000) . But it must be kept in mind that one of NCI's primary
source of funds was NextBank And from a supervisory
perspective, NC l was also viewed as a source of capital support as
reflected in the Board Resolution as requested by OCC after the
2000 examination . OCC's authority to proactively exam NCI,
affiliates, and third party service providers is established unde r
12 U .S .C .§ § 481 and 1867(c) . We believe that examiners in
2000 did not fully exercise this authority .
Recommendation s
With respect to NextBank's Internet-based credit card activities,
the OIG has no recommendations in light of the Federal Financial
Institutions Examination Council's draft Credit Card-Account
Management and Loss Allowance Guidance, July 22, 2002 . While
not applicable to NextBank's entire situation, we believe the
guidance provides sufficient regulatory expectations that would
have mitigated some of the failed bank's risky practices .
1 4 A similar supervisory gap was reported by the FDIC o[G involving another bank failure that had resulted in a material lass to
the FOX . Material Loss Review - The Failure of Pacific Thrift and Loan Company, Woodland Hills, California, dune 7 . 2000 . Audit
Report No . 00-022-
Material Loss Review of NextBank, NA (OIG-03-024) Page 36
In Finding 2, we noted that exarrliner resource constraints appeared
to have hindered OCC's timely and full assessment of the bank's
risk profile and true financial condition until the last quarter in
2001 . We are aware that a similar situation had been identified in
an OCC Lessons Learned Review for another recently failed bank .
One recommendation from that internal review was for OCC to
establish a process to allocate specialized examination resources to
banks that appear fundamentally sound but have a high or
increasing risk profile . This process should be centralized to allow
such specialized requests and assigning resources .
1 . Accordingly, we support the aforementioned
recommendation from the lessons Learned Review and
further recommend that additional steps be taken to
proactively expand the pool of examiners with
specialized experience based on emerging trends and
industry developments .
Also in Finding 2, we noted additional and expanded examiner
attention had been warranted in the areas of accounting practices
and the service agreement with NCI .
2 . With respect to the accounting practice issue, we
recommend that the July 2000 Internal and External
Audits handbook be reassessed for clarity and whether
NextBank's situation calls for establishing or increasing
mandatory procedures to review the external auditors
work covering a bank's accounting practices with .
respect to compliance with Generally Accepted
Accounting Principles .
3 . With respect to the service agreement issue, we
recommend that examiner guidance be reassessed for
clarity or expanding the expected examiner coverage
provided under OCC Bulletin 2001-47 Third-Party
Relationships-Risk Management Principles . The bulletin
establishes precise expectations of banks' risk
management processes . However, it's unclear as to
what examiners are expected to do when a bank's
systems are insufficient or absent as in NextBank's case .
Specific consideration should be given to examiner s
Material Loss Review of NextBank , NA (OIG-03 .024 )
. Page 37
I
gauging a third party service provider's impact on the
bank's condition and operations .
In Finding 2, we also pointed out the possible PCA violation of
increased brokered deposits contrary to the associated
restriction .
4 . We recommend that OCC assess how much of the
increase in brokered deposits in the fourth quarter of
2001 was actually due to the reclassification of fiduciar y
deposits, and assess the need for further sanctions if
warranted .
In Finding 3, we point out two potential vulnerable areas dealing
with change-in-control applications, and oversight of national
bank parent companies that are not subject to Federal
supervision or sufficient supervision by the functional regulator .
5 . With respect to applications, we recommend that OCC
seek legal clarity as to their authority to condition a
change-in-control application . If needed, seek legislative
authority in concert with the Federal Reserve as to the
circumstances allowing OCC to invoke conditions when
acting on this type of application .
6 . With respect to the second issue, the Comptroller of the
Currency should reassess the adequacy of existing
examination guidance on how examiners should assess
the risks presented by the parent company . Added
consideration should be given to the specific supervisory
issues presented by entities operating under the
Competitive Equality Banking Act of 1987 .
Management Response and ©IG Comments
In its November 25, 2002 written response to the OlG's draft
report, OCC concurred with the reported findings and agreed that
the recommendations, when implemented, may be helpful to
avoiding similar situations in the future . Over the next few weeks,
OCC plans to formulate action plans detailing the steps they will
take to implement the recommendations . The actions will beMaterial Loss Review of NextBarik, NA {OIG-03-0241 Page 38
formally reported and monitored through the Department's Joint
Audit Management Enterprise System .
We believe OCC 's planned actions are responsive to the intent of
the recommendations . The OIG will also continue to monitor
OCC's progress in addressing the reported findings and
recommendations . The full text of OCC' s response is included in
Appendix 4 .
We would like to extend our appreciation to OCC for the
cooperation and courtesies extended to our staff during the audit .
If you have questions please call me at (415) 977-8810 ext . 222 .
Major contributors to the report are listed in Appendix 5 .
Benny W . Lee IS f
Regional Inspector General for Audi t
Material Loss Review of NextBank, NA (OIG-03-024} 'age 39
Appendix i
Objectives, Scope . and Methodolog y
We conducted this material loss review of NextBank in response to our
mandate under Section 38(k ) of the FDIA, 12 USC § 1831 o (k) . This
section provides that if the deposit insurance fund incurs a material loss
with respect to an insured deposito ry institution on or after July 1, 1993,
the inspector general for the appropriate Federal banking agency shall
prepare a report to the agency , which shall :
Ascertain why the institution's problems resulted in a material
loss to the insurance fund ;
Review the agency's supervision of the institution ; and
Make recommendations for preventing any such loss in the
future .
As defined by Section 38(k) of the FDIA, a loss occurring after
June 30, 1997, is considered material if it exceeds $25 million o r
2 percent of the institution's total assets . The FDIA also requires the
inspector general to complete the report within 6 months after it becomes
apparent a material loss has been incurred . We initiated a material loss
review of NextBank based on the loss estimate by the FDIC . I n
October 2002, FDIC estimated that NextBank's failure would cost the
Bank Insurance Fund between $300 and $350 million .
To accomplish our review, we conducted fieldwork at OCC Headquarters
in Washington, D_C ., and its Western District Headquarters i n
San Francisco, California . Additionally, we visited FDIC's Division of
Supervision in Washington, D .C ., the Division of Resolutions and
Receiverships (DRR) in Dallas, Texas and Division of Finance (DOF)
personnel operating out of NCI's Headquarters in San Francisco,
California .
We also met with enforcement officials from the SEC in San Francisco,
California to determine the nature and status of any planned or ongoing
investigations relating to NCI . At the time of our inquiry, SEC had just
filed notice of a formal investigation, and as such SEC was unable to
comment . Given the potential breadth of SEC's investigative subpoenas,
we did not inquire or seek information surrounding NCI's external auditors
with respect to any services provided to NCI or NextBank . Accordingly,
our review did not assess what, if any, role the external auditors work
may have contributed to NextBank's failure .
Material Loss Review of NextBank , NA (GIG-03-024)
Page 40
Appendix 1
Objectives, Scope, and Methodolog y
Our review covered the period from December 1997 until NextBank's
failure on February 7, 2002 . We conducted our fieldwork fro m
April 2002 to November 2002 . In November 2002, subsequent to
issuance of our draft report, OCC issued their Lessons Learned Review of
NextBank . Consequently, we were unable to do an in-depth analysis of
any information the review might have had with respect to the causes of
NextBank's failure or OCC's supervision of the bank . However, reviewing
the document shows it is consistent with our audit report .
To assess the adequacy of OCC's supervision of Nextdank, we attempted
to determine (1) when OCC first identified NextBank's safety and
soundness problems, (2) the gravity of the problems, and (3) the
supervisory response OCC took to get the bank to correct the problems .
Additionally, we attempted to determine whether OCC (4) might have
discovered problems earlier, (5) identified and reported all the problems,
and (6) issued comprehensive, timely, and effective enforcement actions
that dealt with any unsafe or unsound activities . Specifically, we :
• Assessed OCC actions based on its internal policies and
guidance, and various guidance provided by the FFIEC .
Reviewed supervisory and enforcement files and records for
NextBank and its parent from 1997 through 2002 that were
maintained at OCC .Headquarters, and its Western District
Office . We analyzed all examination reports, supporting
workpapers, and related supervisory and enforcement
correspondence . We performed this analyses to gain an
understanding of the problems identified, the approach and
methodology OCC used to assess NextBank's condition and
the regulatory action used by OCC to compel bank
management to address the deficient conditions found . We
did not conduct an independent or separate detailed review
of the external auditor's work or associated workpapers,
other than those incidentally available through the
supervisory files .
• Interviewed and discussed various aspects of the supervision
of NextBank with OCC officials, examiners, specialists,
attorneys, and an analyst, to obtain their perspective on the
bank's condition and the scope of the examinations .
Material Loss Review of NextBank , NA (0IG-03-024)
Pape 41
Appendix 1
Objectives . Scope . and Methodolog y
• Reviewed files , workpapers , and examination reports
maintained by FDIC' s Dallas DRR staff to determine the
nature , scope, and conclusions regarding the post closing of
NextBank .
Interviewed the FDIC, DRR and DOF personnel who were
involved in the receivership process and in the due diligence
reviews, which were conducted prior to and after
NextBank's closure and appointment of the conservator .
• Discussed the progress of FDIC' s investigative efforts with
FDIC DRR investigators in Dallas, Texas .
• We interviewed a FDIC Division of Supervision examiner who
had participated with 0CC on reviews and examinations at
NextBank .
We conducted our review in accordance with generally accepted
government auditing standards .
Material Loss Review of Next5ank, NA (OIG-03-024) Page 42
I
Appendix 2
Chronology of Significant Event s
Chronology Of Events in NextBank's Histor y
06/96
Internet Access Financial Corporation, subsequently renamed
NextCard, Inc . (NCI) in October 1998, is incorporated in the . State of
California to offer Internet-based consumer financial services .
12123197 The NCI Visa is first offered to the public , with loans originating
through the NCI website . Credit cards are issued solely through a
strategic alliance with an unaffi li ated bank .
12/10/98 NCI files a cha rt er application with 0CC for a new national bank .
01/12199 NCI terminates its Consumer Credit Card Program Agreement with its
strategic partner and begins purchasing credit card receivables from the
partner using secured lending facilities extended to a subsidiary, NC!
Funding Corporation .
02/16/99 OCC and FDIC conduct charter field investigation .
05/08/99 OCC grants NC[ conditional approval to establish a new national,
limited purpose credit card bank . Conditions include minimum capital
greater than 6 .5 percent of managed assets and limiting securitizations to
not more than 73 percent of aggregate receivables for three years .
05119199 NCI completes its Initial Public Offering (IPO) with gross proceeds
of approximately $138 million .
07/99
FDIC's San Francisco Regional Office recommends denial of insurance,
based on excessive stock-based compensation to insiders and
noncompliance with its statement of policy on stock benefit plans .
08/16199 NCI files notice to acquire the charter of Textron National Bank ( TNB) of
Costa Mesa , California an almost dormant bank , insured by FDIC .
09/15199 NCI's change in control becomes effective . TNB is renamed NextBank,
National Association, a new limited purpose national credit card bank .
Total Assets were about $313 million by September 30, 1999 .
Material Loss Review of NextBank, NA (01G-03-024) Page 43
Appendix 2
Chronology of Significant Event s
12106199 OCC conducts a 60-day limited scope examination of NextBank as of
September 30, 1999 . CAMELS 2/222322 .
12/14/99 NCI completes a follow-on public offering with gross proceeds of
approximately $161 million .
03/00
Founder, Chairman and CEO of NCI steps down, retained
as Chief Strategy Officer .
05108100 . OCC begins first full scope examination based on March 31, 2000 data .
Total Assets as of March 31, 2000 were $696 million .
05100 NextBank submits a revised business plan for 2000 .
0711 1100 FDIC requests to attend exit meeting due to concerns about rapid growth,
increasing risk profile and lack of controls .
7/00 OCC requested NCI's Board Of Directors to develop a Capital Assurance
Agreement between the bank and NCI .
09/06/00 OCC holds an exit meeting with NextBank on the May 2000 examination .
OCC concludes that the bank's condition is satisfactory and assigns
CAMELS ratings of 2/222322 . FDIC has reservations with OCC's
ratings, but concurs, lacking information that would substantiate a lower
rating . Total managed assets were $951 million at June 30, 2000 .
10126 1 00 Based on the May 2000 examination, NextBank's Board of Directors
adopts Board Resolution including a Capital Assurance Agreement .
12/00 OCC on-site visit to review NextBank corripliance with the Board
Resolution . OCC finds that NextBank made minimal progress in
addressing issues raised in the Board Resolution and asset quality issues .
01/01
NextBank issues new Capital and Business Plans .
01/02/01 OCC on-site review of NextBank securitizations and compliance with
Board Resolution . OCC considers securitization activity satisfactory .
However NextBank is not in full compliance with Board Resolution . OCC
asks NextBank management to re-write the Capital and Business Plans .
Material Loss Review of NextBank, NA (OIG-03-024) Page 44
I
Appendix 2
Chronotogy of Significant Event s
03/01 OCC on-site visit to evaluate NextBank's compliance with Board
Resolution . OCC finds only partial compliance .
05101 OCC begins a full scope examination, with FDIC participating . NextBank
expanding subprime loan market, growing greater than planned, planning
and control systems not keeping up . with growth, and the bank deviates
from original business plan . Total managed assets $1 .9 billion as of
March 31, 2001 .
07/13/01 OCC transfers NextBank supervision from .he Western District to its
Washington, D .C . Headquarters Special Supervision and Fraud Division .
08120101 OCC begins Phase 2 of the full scope examination with an expande d
team of specialized examiners .
09/30/01 OCC examiners ascertain NexiBank's true financial condition, leading to a
reduction of its capital position by $96 million . OCC deems that
NextBank is providing implicit recourse on securitized assets . Total Risk
Based Capital is reduced to 5 .38 percent, placing NextBank in the
"significantly undercapitalized" PCA category .
10/04/01 NCI retains outside investment bank to market the parent and bank for
sale, likely indicating that management is unwilling or unable to improve
NextBank's capital position .
1 1109/01 OCC asks NextBank's Board of Directors to request in writing that NCI
provide capital support as required under the Capital Assurance
Agreement .
1 1116101 OCC issues a PCA Directive requiring NextBank to file an acceptable
Capital Restoration Plan with OCC by December 31, 2001, or a plan to
sell/merge/liquidate at no cost to the FDIC .
12131/01
NextBank files a Capital Restoration Plan with OCC proposing eithe r
the sale of NCI to a third party or a liquidation of NextBank's assets and
liabilities .
01112102 NextBank files an Asset Disposition Plan with OCC since a Capital
Restoration Plan is not feasible . The Asset Disposition Plan is
unacceptable to 0CC and FDIC because of its high cost, lack o f
Material Loss Review of NextRank, NA (OIG-03-024) Page 45
I
Appendix 2
Chronology of Significant Event s
assurance that a buyer could be found, and inability to raise enough
money to retire the bank's liabilities .
02/07102 0CC issues a Temporary Cease and Desist Order requirin g
NextBank to take action to enforce the Capital Assurance Agreement
between the bank and NCI .
02/07/02 0CC issues an Order of Investigation requiring NextBank t o
provide documents needed to assess the financia l condition and evaluate
the a ff airs of NextBank and to determine whether any enforcement action
is appropriate against directors , officers, or employees of the bank .
2/07/02 OCC closes NextBank and names FDIC as Receiver .
03/02
SEC opens an investigation of NCI .
Material Loss Review of NextBank, NA (OIG-03-024) Page 46
I
Appendix 3
Glossary of Term s
Allowance for Loan and A valuation reserve established and maintained by
Lease Losses charges against a bank's operating income . As a
valuation reserve, it is an estimate of uncollectable
amounts that is used to reduce the book value of loan s
and leases to the amount that is expected to be
collected .
Brokered Deposits Funds, which a bank obtains, either directly or
indirectly, by or through a broker . for deposit into a
deposit account . Brokered deposits include both those
in which a single depositor holds the entire beneficial
interest and those in which the deposit broker sells
participations to one or more investors . Under 12 Code
of Federal Regulations § 337 .6, only "well capitalized"
banks may accept brokered deposits without FDIC
approval .
CAMELS The OCC and other bank regulators use the Uniform
Financial Institution Rating System to evaluate a bank's
performance . CAMELS are an acronym for the
performance rating components : C apital adequacy,
Asset quality, Management administration, Earnings,
Liquidity, and Sensitivity .
Implicit Recourse An implied obligation for the bank to make good all
credit losses in accounts sold .
Individual Minimum OCC may establish the minimum level of capital for an
Capital Requirement institution it supervises . This enforcement action is a
special capital requirement set case-by-case fo r
associations with unacceptably high-risk profiles .
Informal and Formal Informal enforcement actions are documents that
Enforcement Actions provide a bank with guidance in addition to tha t
provided by the Report of Examination . Informal
actions are those instances where it is desirable to have
commitments from a bank's management and board of
directors . Formal enforcement actions are reserved for
significant safety and soundness or complianc e
Material Loss Review of NextBank , NA (OIG-03-024)
Page 47
Appendix 3
Glossary of Terms
problems that, unless corrected, constitute a present or
future threat to the survival of the bank or otherwise
pose a serious threat to the bank's safety and
soundness .
Order of Investigation Orders approved by Washington Supervision Review
Committee and the Senior Deputy Comptrolier for Bank
Supervision Operations, which authorize formal
investigations of certain national banks . Once issued
the Comptroller's representatives are authorized to
subpoena documents and testimony from the entities
within and outside the bank under investigation .
Prompt Corrective Action A framework of supervisory actions for insured
institutions, which are not adequately capitalized .
These actions become increasingly severe as an
institution falls into lower capital categories . The
capital categories are : Well Capitalized, Adequately
Capitalized, Undercapitalized, Significantly
Undercapitalized, and Critically Undercapitalize d
(12 USC § 1831o) .
Subprime The term refers to the credit characteristics of the
individual borrowers . Subprime borrowers typically
have weakened credit histories that include payment
delinquencies, and possibly more severe problems such
as charge-offs, judgments, and bankruptcies . They
may also display reduced repayment capacity as
measured by credit scores, debt-to-income ratios, or
other criteria that may encompass borrowers with
incomplete credit histories .
Temporary Cease &
Interim order to impose immediate measures pending
Desist Order resolution of a final cease and desist order . May b e
challenged in U .S . District Court within 10 days of
issuance but effective on issuance . Pursuant to
authority under 12 USC § 1818 .
Material Loss Review of NextBank, NA (OIG -03-024) Page 48
Appendix 4
Management Comment s
C
MEMORANDUM
Comptroller of the Currency
Aoministrator of National Banks
wasnlnQtan, DC 2021 9
Ta : Benny W. I. , Regiondl Inspector Gene al for Audit
From : John D . Hawke, Jr.. Comptroller of the Curremy
Dato : November 25r 200 2
Suhitct: OTC Draft Audit Report -NextBank N .A .
We have tooeived and reviewed your draft audit report titled Murerial Lass Review of NerzBa*
X .A. The Office of the Cornptrol1a of the Cuzrecy closed Ncx zz3c, N . (NcxtBank) on
February 7, 2002 upon determining that unsafe and unsound practices had substsnriaily
dissipazcd asses and that insolvency was imminent without Federal assistance . The Fedora[
Deposit Iastuaace Act m =dated your review of the failure, because the Federal Deposit
lnsusance Corporation (FDIC) estimated that there would be a material loss to the deposit
insurance fund.
Consistent with the purposes of the rcv'saw, you found that the bank failed because of improperly
rnszuayed rapid'owth tb& led to unacceptable high levels of credit risk, losses, and opanwoaal
probless. You also found that thac ware aspects of OCC's exam
on and entbruramt
prooedures that warrant closer review and assessment given the rapidity of Ncxt8ank's
uncontrolled ltowth and failure.
We concur with your fmd€ngs and area that the nxomtrtcadations, when impiemeineed, may be
helpful to us in avoiding similar sit iations in the future . Over the next few weeks, we will be
formuladag action plans derailing the steps we will taka to implement the recotnutendations .
The ac ions will be fonually reported and monitotcd through the Dcpar=cnt'a Joint Audit
Management Eraerpsise System (JAxAES) .
Thank you for the appottunlty to review and coz=enr on the draft report.
Material Loss Review of NextBank, NA (OiG-03-O24) Page 49
Appendix 5
Major Contributors To This Repor t
inspector General, Office of Audi t
John A . Richards, Audit Manage r
John E . Carnahan, Auditor-in-Charg e
Jack Gilley, Audito r
John Mansfield , Audito r
Garrett W. Gee, Audito r
Material Loss Review of NextBank, NA {OlG-03-024) Page 50
Appendix 6
Report Distributio n
U .S . Department of the Treasur y
Office of the Under Secretary for Domestic Financ e
Office of the Assistant Secretary for Financial Institutions Policy
Office of Strategic Planning and Evaluations . Departmental Offices
Office of Accounting and Internal Control, Departmental Offices
Office of the Assistant Secretary for Public Affair s
Office of The Comptroller of the Currency
Comptroller
Deputy Comptroller Western District
Senior Advisor-OIGfGAO Liaiso n
Office of Management and Budge t
OIG Budget Examine r
U .S . General Accounting Office
Comptroller of the United State s
Federal Deposit Insurance Corporatio n
Chairma n
Material Loss Review of NextBank, NA (OfG-03-0241 Page 51
I
Exhibit 2
KEVIN Y . RYAN (CSBN 118321)
United States Attorney
FILE?
CHARLES B . BURCH (CABN 79002)
Chief, Criminal Division
AUG 14 2003
2
3
4
5
s
7
ANNE-CHRISTINE MASSULLO (CASBN 117506)
WILLIAM H . KIMBALL (NYSB 2358687)
Assistant United States Attorney
P.lOHAfo W . WIE KW G
C!E( U-9M TRFCT C jfl '
1BNO1STHr-T OrCA F(>WtA
450 Golden Gate Avenue, Box 36055
San Francisco , California 94102
Telephone: (415) 436-684 2
8 1 Attorneys for Plaintiff
g
UNITED STATES DISTRICT COURT
10
NORTHERN DISTRICT OF CALIFORNI A
11
SAN FRANCISCO DIVISIO N
12
23
UNITED STATES OF AMERICA, No . CR 03-0229 JSW
14
Plaintiff,
PLEA AGREEMENT
15
v.
16
OLIVER G . FLANAGAN,
17
Defendant.
18
19
1, Oliver G. Flanagan, and the United States Attorney's Office for the Northern
20
District of California (hereafter "the government") enter into this written plea agreement
21
(the "Agreement") pursuant to Rule 1 I(c)(1)(13) of the Federal Rules of Criminal
22
Procedure :
23
The Defendant's Promises
24
1 . I agree to waive indictment and plead guilty to the captioned information
25
charging me with obstructing an examination oCa financial institution, in violation of 18
26
U .S .C_ § 1517 . 1 agree that the elements of the offense and the maximum penalty for thi s
27
28
PLEA AGREEMENT
F46" If f ;'r-11FD2-SQ;!F A
CR 03-0229 JSW
i
charge are as follows : (1) the Office of the Comptroller of the Currency of the
2
Department of the Treasury ("OCC"), an agency of the United States with jurisdiction to
3
conduct examinations of financial institutions ; (2) was conducting an examination of a
4
bank that was a financial institution as defined by 18 U .S .C . § 20 ; (3) 1 was aware that
5
there was an ongoing OCC examination ; (4) 1 obstructed or attempted to obstruct the
6
examination by taking actions, whether or not successful, that had the natural and
7
probable effect of obstructing the examination; and (5) 1 did so corruptly, in that I acted
8
voluntarily and deliberately and for an improper purpose .
I also agree that the maximum penalties are as follows :
9
10
a . Maximum prison sentence 5 year s
11
b. Maximum fine S 250,000 .00
12
c. Maximum supervised release term 3 years
13
d . Mandatory special assessment $ 100 .00
14
e. Restitution
15
f Other possible consequences of guilty plea :
N/A
16
A guilty plea to a felony may affect my ability to become a United
17
States citizen should I ever apply for citizenship in this country .
is
19
20
21
22
2 . 1 agree that t am guilty of the offenses to which I will plead guilty, and I
agree that the following facts are true :
Beginning on April 17, 2000, 1 was employed by the San Francisco offic e
of Ernst & Young LLP ("E&Y") as a Senior Manager to work on various independent
23
audits performed on both private and public corporations which were client s of the firm .
24
25
As Senior Manager, I worked under the audit partner for the client ' s engagement and was
26
responsible , among other things, to review work completed by members of the audit team .
27
-28
PLEA AGREEMENT
FILED UNDER SEAL
CR 03-0229 JSW
2
I was also responsible to sign-off on the audit work once it was finalized so that the
2
electronic version of the audit could be archived in the automated work paper system
3
4 ("AWS") developed by E&Y . The AWS archives audit work papers on a national
computer server where they are maintained as a permanent record of the client's audit . In
6
addition, a hard copy of audit work papers which are not electronically generated, such as
7
g letters containing original signatures, is maintained in the file room at-E&Y9 111
10
NextCard, Inc . ("NextCard")a publically traded corporation which provided
online credit card application services and traded on the nationwide automated quotation
11
:12 system ("NASDAQ") under the symbol "NXCD", was an E&Y client . NextBank, N .A.
13 (NextBank") was a subsidiary of NextCard and a Financial institution whose deposits
14
were insured by the Federal Deposit Insurance Corporation ("FDIC") . Beginning in the
15
16 second quarter of 2000, 1 was assigned to work as the Senior Manager on . the NextCard
17 engagement . My supervisor on the NextCard engagement was Thomas Trauger . Trauger
18
became a partner of E&Y in October 2000 .
19
20 In about March 31, 2001, the Office of the Comptroller of the Currency of
21 the Department of the Treasury ("OCC") conducted an examination of NextBank, which
22
was a wholly owned subsidiary of NextCarcl . Beginning in the summer of 2001 and
23
24 continuing through March 1, 2002, Trauger, with my assistance and the assistance of
25 others, altered the 2000 NcxtCard audit workpapers and the quarterly reviews generated
26
by the engagement team for the first and second quarters in 2001 . Among other things,
27
28
PLEA AGREEMENT
FILED UNDER SEA L
CR 03-0229 JSW 3
Trauger altered spreadsheets requested by and given to the OCC ; deleted and altered
2
information contained in a memorandum generated in support of the 2000 audit ;
3
4 instructed me to obtain original handwriting on an altered spreadsheet so that it would
5 appear to be the original ; altered information contained in the 2000 NextCard archived
S
audit; and instructed me to rearchive the 2000 audit after the changes were made which
7
g had the effect of deleting the original archived version . These deletions and alterations
-9
were made so that the .OCC would conclude that our audit was more soundly based than it
10
actually was .
13
12 On March 1, 2002, the OCC issued a subpoena duces tecum to the San
13 Francisco office of Ernst & Young LLP, c/o Tom Trauger . The subpoena required that
1.4
on or before March 25, 2002, E&Y produce "[a]ny and all documents relating to
15
16 NextBank, N .A.; NextCard, Inc . ; NextCard Limited, NextCard Funding Corp . and/o r
1 '7
NextCard Credit Card Master Note Trust ." After receiving the subpoena, Trauger tasked
18
me with the responsibility of gathering all documents that were responsive to the OCC
19
20 subpoena . Thereafter I requested that members of the audit team provide me with
21 responsive documents . At some point during this process, I noticed that I had in my
22
office the zip disk of the former Senior Auditor for the NextCard engagement which
23
24 contained her electronic files for the 2000 NextCard audit . When I informed Trauger of
25 the existence of the zip disk, he told me that it was not important and to get rid of it . He
26
also instructed €l e to review my computer and to delete any e-mails or files which might
27
28
PLEA AGREEMENT
FILED UNDER SEA L
CR 03-0229 JSW 4
I
s
reflect the alterations we made to the NextCard audit in November 2001 . Thereafter I
2
went to my computer, reviewed c-nails and Files and deleted at least two items that woul d
3
4
reflect the alterations made to the 2000 audit . Similarly, I followed Trauger's instructio n
5
and did not provide the zip disk to the OCC ( although I did not destroy or alter it and
6
recently made it available to the government.) . At the time I engaged in this conduct, I di d
7
8
so voluntarily, deliberately and with the improper purpose of concealing the prio r
9
alterations from the OCC .
to
3 . 1 agree to give up all rights that I would. have if I chose to proceed to trial ,
11
12
including the rights to a jury trial with the assistance of an attorney ; to confront and cross-
13
examine government witnesses ; to remain silent or testify; to move to suppress evidenc e
14
or raise any other Fourth or Fifth Amendment claims ; to any further discovery from th e
15
16
17
government, and to pursue arty affirmative defenses and present evidence .
4, 1 agree to give up my right to appeal my conviction, the judgment, an d
i8
I orders of the Court_ I also agree to waive any right I may have to appeal my sentenc e
19
20
21
I except that I reserve the right to appeal the denial by the district court of any motion mad e
by the Government pursuant to Guidelines Section 5K1 .1 based upon my provision o f
22
23
24
I substantial assistance in the investigation or prosecution of another person.
5. 1 agree not to file any collateral attack on . my conviction or sentence ,
25 I including a petition under 28 U .S .C . § 2255, at any time in the future after I a m
26
27
I sentenced, except for a claim that my constitutional right to the effective assistance o f
28
PLEA AGREEMENT
FILED UNDER SEAL
CR 03-0229 JSW
5
I
x
counsel was violated .
2
6.
1 agree not to ask the Court to withdraw Illy guilty plea at any time after it i s
3
entered.
4
' . I agree that I will make a good faith effort to pay any fine, forfeiture o r
5
6
restitution I am ordered to pay . Before or after sentencing, I will, upon request of th e
7
8
Court, the government, or the U .S . Probation Office, provide accurate and complet e
s
financial information, submit sworn statements and give depositions under oath
10
concerning illy assets and my ability to pay, surrender assets I obtained as a result of my
11
12
crimes, and release funds and property under my control in order to pay any fine ,
13
forfeiture, or restitution . I agree to pay the special assessment at the time of sentencing .
14
S . I agree to cooperate with the U .S . Attorney's Office before and after I a m
15
16 Ili I
17
18
sentenced . My cooperation will include, but will not be limited to, the following :
a . I will respond truthfully and completely to any and all questions put to axle,
whether in interviews, before a grand jury or at any trial or other
proceeding ;
19
20
b . I will provide all documents and other material asked for by the
government ;
21
22
c . I will testify truthfully at any grand jury, court or other proceeding as
requested by the government ;
23
24
d. I will surrender any and all assets acquired or obtained directly or indirectly,
as a result of my illegal conduct ;
25
26
e . I will request continuances of my sentencing date, as necessary, until my
cooperation is completed;
27
28
PLEA AGREEMENT
FILED UNDER SEAL
CR 03-0229 JSW
6
f. I will tell the government about any contacts I may have with an y
2 co-defendants or subjects of investigation, or their attorneys or individuals
employed by their attorneys ;
3
4
g . I will not reveal my cooperation, or any information related to it, to anyone
without prior consent of the government.
5
6
9. 1 agree that the government's decision whether to f le a motion pursuant to
7 U .S .S .G . § 5K1 .1, as described in the government promises section below, is based on its
8
sole and exclusive decision of whether I have provided substantial assistance and that
9
10 decision will be binding on me . I understand that the government's decision whether to
11 file such a motion, or the extent of the departure recommended by any motion, will not
12
depend on whether convictions are obtained in any case . I also understand that the Court
13
14 will not be bound by any recommendation made by the government .
15 10 . I agree not to commit or attempt to commit any crimes before sentence is
16
17
imposed or before I surrender to serve my sentence ; violate the terms of my pretrial
18 release (if any) ; intentionally provide false information or testimony to the Court, the
19 Probation Office, Pretrial Services, or the government ; or fail to comply with . any of the
20
21
other promises I have made in this Agreement . I agree that, if I fail to comply with any
22 promises I have made in this Agreement, then the government will be released from all of
23 its promises, but I will not be released from my guilty plea .
24
11 . If I am prosecuted after failing to comply with any promises I made in this
25
26 Agreement, then (a) I agree that any statements I made to any law enforcement or other
27 government agency or in Court, whether or not made pursuant to the cooperatio n
28
PLEA AGREEMENT
FILED UNDER SEA L
CR 03-0229 JSW 7
provisions of this Agreement, may be used in any way; (b) I waive any and all claims
2
under the United States Constitution, Rule 11(e)(6) of the Federal Rules of Criminal
3
4 Procedure, Rule 410 of the Federal Rules of Evidence, or any other federal statute or rule,
-5
6
7
I
to suppress or restrict the use of nay statements, or any leads derived from thos e
statements ; and (c) E waive any defense to any prosecution that it is barred by a statute of
8 limitations, if the limitations period has run between the date of this Agreement and the
9 date I am indicted .
10
12 . I agree that this Agreement contains all of the promises and agreements
11
12 between the government and nme, and I will not claim otherwise in the future .
13 13 .
1 agree that this Agreement binds the U .S . Attorney's Office for the
14
15
Northern District of California only, and does not bind any other federal, state, or local
16 agency.
17
The- Government's Promises
18
14 . The government agrees to move to dismiss any open charges pending
2 against the defendant in the captioned i-r -ie ent at the time of sentencing .
21 15 . The government agrees not to file or seek any additional charges against the
22
defendant that could be fi led as a result of the investigation that led to the pending
txne€rt.~25
16 . The
government agrees not to use any statements made by the defendan t
26
27
pursuant to this Agreement against hi m , unless the defendant fails to comply with any
28
PLEA AGREEMENT
FILED UNDER SEA L
CR 03-0229 JSW g
I
promises in this agreement. The government may, however, tell the Court and the U .S.
Probation Department about the full extent of the defendant's criminal activities i n
connection with the calculation of the Sentencing Guidelines .
17. If, in its sole and exclusive judgment, the government decides that th e
defendant has cooperated fully and truthfully, provided substantial assistance to la w
enforcement authorities within the meaning of U.S .S.G . § 5K 1 . 1, and otherwise complie d
fully with this Agree ment, it will file with the Court a motion under § 5K1 .1 and/or 1 8
U .S .C . § 3553 that explains the nature and extent of the defendant's cooperation an d
recommends a downward departure .
18 . Based on the information now known to it, the government will not oppos e
a downward adjustment for acceptance of responsibility under U .S.S.G . § 3E1 .1 .
The Defendant's Affirm ations
1 9 . 1 confirm that I have had adequate time to discuss this case, the evidence ,
I and this Agreement with my attorney, and that he has provided me with all the lega l
I advice that I requested .
20.
1 confirm that while I considered signing this Agreement and, at the time I
signed it, l was not under the influence of any alcohol, drug, or medicine .
U/
(11
I II
PLEA AGREEMENT
FILED UNDER SEA L
CR 03-0229 JSW 9
21 .
2
1 confirm that rimy decision to enter a guilty plea is made knowing th e
charges that have been brought against me, any possible defenses, and the benefits an d
3
4
possible detriments of proceeding to trial . I also confirm that my decision to plead guilty
5
is made voluntarily , and no one coerced or threatened me to enter into this agreement .
6
Dated :
Op `fi
r
UUVLER G . FL AN
Defendan t
lad2e-~
7
8
KEVIN V . R`: AN
Unrtates Attorney
9
10
11
Dated: Pk- 1 q 5
ANNE-CHRISTINE MASSULLO
Assistant United States Attorney
12
13
14
15
I have fully explained to my client all the rights that a criminal defendant has and al l
the terms of this Agreement . In my opinion, my client understands all the terns of thi s
16
Agreement and all the rights he is giving tip by pleading guilty, and, based on the
17
is
19
information now known to mc, his decision to p1 d guilty is knowing and voluntaryDated(~~
20
U3
• STANLEY . A iN
Attorney for Defendan t
21
22
23
24
25
26
27
28
PLEA AGREEMENT
FILED UNDER SEAL
CR 03-0229 JSW
10
1
Stanley S . Arkin ( SBN No . 058951 ) (Pro Hac Vice) FIED
ARKIN KAPLAN LLP
2
590 Madison Avenue, 35th Floo r
New York, New York 10022
3
4
Telephone : ( 212) 333-0200
Facsimile:
(212) 333-2350
AUG 14 2Q03
Irnarao~'csra "
Alfred E . Augustini ( SBN No . 043204 )
5
7
AUGUSTINI & WHEELER LLP
523 W. 6th Street, Suite 300
Los Angeles, California 90014-1226
Telephone : (213) 629-888 8
Facsim ile: (213 ) 688-7600
8
Attorneysfor Defendan t
6
9
UNITED STATES DISTRICT COURT
10
NORTHERN DISTRICT OF CALIFORNI A
II
--------------------------------------------------------- x
12
UNITED STATES OF AMERICA,
13
Plaintiff,
- against -
17
18
. APPLICATION FOR PERMISSIO N
. TO ENTER PLEA OF GUILT Y
14
15
16
. Index No .: CR-03-0229 JS W
:
AND ORDER ACCEPTING PLE A
OLIVER G . FLANAGAN ,
Defendant .
---------------------------------------------------------- x
19
20
The defendant represents to the Court:
21
1 . My full true name is Oliver Gerard Flanagan . I am 34 years of age . I have gone lo
22
school up to and including College . My most recent occupation has been auditor . I request that al l
23
proceedings against me be in my true name .
24
2. 1 am represented by a lawyer ; his name is Stanley S . Arkin .
25
3. I received a copy of the information before being c al led upon to plead . I have read
26
the information . I fully understand every charge made against me . I understand these charges to b e
27
that I interfered with an investigation by a federal agency into a fi nancial institution by assisting my
28
supervisor in producing altered documents to the agency in response to a request , and, after a
APPLICATION FOR PERMISSION FILED L r 03 - 0229 JS W )
EQ 17d 8. D0C
I
1
subpoena was issued, by deleting electronic files and originally withholding a zip disk that wa s
2
responsive to the subpoena .
3
4 . 1 have told my lawyer all the facts and circumstances known to me about the charge s
4
made against Ine in the information . I believe that my lawyer is fully informed on all such matters.
5
5 . I know that the Court must be satisfied that there is a factual basis for a plea o f
6
"GUILTY" before my plea can be accepted . I represent to the Court that I did the following acts; in
7
connection with the charges made against me in the information :
O
A
t
(IT"'-
9
10
11
12
13
14
35
16
C, ~- t LA 1
t'
\
e
o 6Le3e~l
17
18
19
20
(In the above space defendant must set out in detail in his /her own handwriting what he did .
21
If more space is needed, add a separate page.)
22
6. My lawyer has counseled and advised me on the nature of each charge, all lesse r
23
included charges, all penalties and consequences of each charge, all possible defenses that I may
24
have in this case and the constitutional rights I am waiving .
25
7 . I understand that my constitutional rights are as follows :
26
(a) the right to a speedy and public trial by jury ;
27
(b) the right to see all of the evidence against me and to hear all witnesses called
to testify against me and to have my attorney cro ss-examine them ;
28
APPLICATION FOR PERMISSION PILED UNDER SEAL (CR 03-0229 ]SW)
EQI 748.DOC
(2 )
I
(c) the right to use the power and process of the court to compel the production
of any evidence, including the attendance of any witnesses in my favor ;
2 (d) the right to the assistance of a lawyer at all stages of the proceeding s
3 including trial and appeal and if l cannot afford one, to have the court appoint
one to represent me without cost to me or based upon my ability to pay ;
4
(e) the right to remain silent or to take the witness stand at my sole option an d if
5 1 do not take the witness stand , no inference of guilt may be drawn from such
failure and the jury must be so advised ;
6
7
(f) the right against self- incrimination ;
(g) the right to appeal from an adverse judgment ;
8
(h) the right to appeal my sentence without any limitation contained in my plea
9 agreement .
10 8 . I know that I may plead "NOT GUILTY" to any offense charged against me and
11 exercise all of my rights as listed above .
12 9 . 1 know that if I plead "GUILTY" I am giving up all of the rights enumerated in
13
paragraph 7 and that there will be no trial either before a court or jury .
14 10 . 1 know that if I plead "GUILTY" the result of Iny plea is more than just an admission
15 or confession of guilt and that it will result in my conviction , and that further , the court may impose
16 the same punishment as if I had pleaded "NOT GUILTY ," stood trial and been convicted by a jury .
17 11 . My lawyer has discussed with me the maximum and minimum , if any, punishm ents
18 which the law provides and the various provisions of the Sentencing Guidelines that may apply to
19 me . I understand that the maximum punishment for the offense charged in the information is 5
20 years of imprisonment and a fine of $250 ,000 . 1 also understand that the maximum period of
21 supervised release which the court may impose is 3 years and that if I violate a lly condition of
22 supervised release the release may be revoked and l may be sentenced to all or part of the term of
23 supervised release imposed in addition to any other term of imprisonment which I have received .
24 I understand that l may be assessed the costs of confinement and/or supervision . I
25 understand that I must pay a penalty assessment of $100 .00 per count to which I plead (or $25 .0:0 in
26 the case of misdemeanor counts) . I understand that I may be ordered to pay restitution in an amount
27 determined by the court .
28
APPLICATION FOR PERMISSION FILED UNDER SEAL, (CR 03 -0279 JSW)
EQ 174S. DOC
(3)
I know that the sentence I will receive is solely a matter within the control of th e
1
2
Judge. I understand that the Judge will make no decision regarding my sentence until the Judge has
3
read and considered the pre-sentence in investigation report prepared and submitted to the court by
4
the Probation Department .
5
6
I also understand that the court and counsel cannot promise what sentence or
sentencing range will be set and that these calculations will depend upon the Sentencing Guidelines
7
as they apply to me . I have been advised that the court may sentence within the guideline range
8
determined by the Probation Department or may depart upward or downward from the range .
9
However, no promises have been made to me as to the range or departure .
10
12 . If I am on probation, supervised release or parole in this or any other court, I know
11
that by pleading guilty here my probation, release or parole may be revoked and I may be required
12
to serve time in that case, which may be consecutive, that is, in addition to any sentence impose d
13
upon me in this case .
14
13 . I declare that no officer or agent of any branch of government (federal, state or local )
15
has promised or suggested that I will receive a lighter sentence, or probation, or any other form of
16
leniency, nor have any other promises been made if I plead "GUILTY," except as stated in the Ple a
17
Agreement I have signed . If anyone else made such a promise or suggestion, except as noted in the
18
previous sentence, I know that person had no authority to do it . No one has forced or coerced me
19
into entering this plea. My willingness to plead guilty does not result from prior discussions
20
between my attorney and the government's attorney, except for those reflected in the Plea
21
Agreement.
22
23
24
14. 1 believe that my lawyer has done all that a lawyer could do to counsel and assist nmc,
and I am satisfied with the advice and help he has given me .
1 5 . I know that the court will not permit anyone to plead "GUILTY" who maintains he is
25
innocent and, with that in mind and because I am "GUILTY," I respectfully request the court to
26
accept my plea of "GUILTY" and to have the clerk enter my plea of "GUILTY" as charged in the
27
information dated July 22, 2003, setting forth one violation of 18 U .S .C . § 1517 .
28
APPLICATION FOR PERMISSION FILED UNDER SEAL ( CR 43-02291SW)
L-QI748 .DOC
(4)
I
1
2
16.
My m ind is clear. I am not under the influence of alcohol or drugs and I am not
under a doctor ' s care . The only drugs, medicines or pills that I took within the past seven days are :
3
4
5
6
17. 1 OFFER MY PLEA OF "GUILTY" FREELY AND VOLUNTARILY AND
7
OF MY OWN ACCORD AND WITH FULL UNDERSTANDING OF ALL THE MATTERS
8
SET FORTH IN THE INFORMATION AND IN THIS APPLICATION AND IN THE
9
CERTIFICATE OF MY LAWYER WHICH IS ATTACHED TO THIS APPLICATION . IN
10
OFFERING MY PLEA OF "GUILTY" I FREELY AND VOLUNTARILY WAIVE ( giveuup)
11
THE CONSTITUTIONAL RIGHTS GUARANTEED TO ME AS STATED IN
12
PARAGRAPH 7 ABOVE.
13
14
15
18 . 1 waive the reading of the information in open court, and I request the court to enter
my plea of "GUILTY" as set forth in Paragraph 15 of this application .
19 . 1 understand that all of the above statements will be made in open court under oath
16
and that any false statements may be used against me in a prosecution for perjury or false statement
37
which is a felony.
18
19
20
20 . 1 am proficient enough in English to read the above and have read and full y
understand it .
21 . Signed by mein open court in the presence of my attorney this date : )442tg~--s
21
22
IVER G . FL AN
23
24
25
26
27
28
APPLUCA'I't01 FOR PERMISSION FILED UNDER SEAL (CR 03-0229 JSW)
EQ1748 .DOC
(5)
CERTIFICATE OF COUNSE L
1
The undersigned , as lawyer and counselor for the defendant Oliver Gerard Flanagan, herb y
I certifies:
22 . I have read and fully explained to the defendant and believe he fully understands the
allegations contained in the information of this case , the defenses he may have to each and every one
of the allegations and the consequences of a plea of "GUILTY ," including the pertinent Sentencin g
I Guidelines provisions and maximum and minis um penalties .
23 . I believe the defendant fully understands the constitutional rights he is waiving and that
9
by entering a plea of "GUILTY" he is waiving each and every one of those rights .
10
24. Nothing has come to my attention which causes nee to believe that the defendant lacks
11
the ability to understand anything contained in the attached application or that at the time of entering
12
his plea he is under the influence of any drug or alcohol .
13
14
15
25. The plea of "GUILTY" offered by the defendant in Paragraph 15 accords with zny
understanding of the facts he related to me and is consistent with my advice to the defendant .
26. In my opinion the defendant's waiver of reading of the information in open court: as
16
provided by Rule 10 is voluntarily and understandingly m ade, and I recommend to the court that th e
17
waiver be accepted by the court .
18
27. Defendant has read the Plea Agreement he signed in the matter and I believe he full y
19
understands it. I certify that no promises have been made to the defendant by the government or
20
myself other than those contained in the Plea Agreement and if there are such other promises I mus t
21
state them on the record before my client and the court .
22
28 . In my opinion the plea "GUILTY" offered by the defendant in Paragraph 15 of tie
23
application is voluntarily and understandingly made . I recommend that the court accept the ple4 of
24
"GUILTY ."
25
26
Signed by me in open court in the presence of the defendant above-named and after full
discussion of the contents of this certificate with the defend tit this date :
z4U__r j 2_0
27
28
STANLE S . RKI N
CERTIFICATE Or COUNSEL UNDER SEAL (CR 03-0229 JSW)
EQ1748 .DOC
ORDE R
1
2
I find that :
3
I . The defendant enters this plea of guilty freely and voluntarily and not out of ignorance,
4
5
G
7
inadvertence, fear or coercion .
2 . The defendant understands and knowingly, freely and voluntarily waives his
constitutional rights .
3 . The defendant freely and voluntarily executed the within Application and understand s
its contents .
9
4 . The defendant has admitted the essential elements of the crime charged .
10
11
12
13
IT IS THE REFORE ORDERED that the defendant ' s plea of "GUIL`T'Y" be accepted and
entered as prayed for in the Application and as recommended in the ce rti fi cate of his lawyer .
Done in open court this date :
? 1 4
14
15
h' H1TE ,
D RTES DISTRICT JUDG E
16
17
18
19
20
21
22
23
24
25
26
27
28
ORDER UNDER SEAL (CR 03-0224 JSW)
EQ t 748.DOC
Exhibit 3
4t) 51 (R:,v . 5185) Cri m omptai n E
mite. States
Rsfrirt
QIirnrt
NORTHERN DIST RICT OF CALIFORNI A
UNITED STATES OF AMERICA
V.
THOMAS C . TRAUGER
-s :1
; - ;.? CRIMINAL COMPLAINT 1
IL
CASE NUMBER:
(Name and Address of Defendant )
~ . ~, ~ .~ , ; ~ ."•,
f~
,.
1 . th e undersigned complainant being duty sworn state the fo l lowing is true and correct to the best o? rrij
knowledge and belief . On or about
NORTHERN
1012001 - 412003
CAL I F ORNIA
District of
in
SAN FRANCISCO
county, it
defendant (s) did, (Tracts Statutory Language of Offense )
SEE ATTACHMENT A
in violation of title
18
1517 AND 1519, AND 2
United States Code, Section(s)
t further state that 1 am a(n) SPECIAL AGENT OF THE FBI and that this complaint is based on the foliowint
a
e
facts :
SEE ATTACHMENT 8
Continued on the attached sheet and made a part hereof :
Yes
No
AppFo
A-s Two.
1
~
Farm: ed
AuSA: WILLIAM H . KIMBALL
Sign
re V Gom"na~t: $A JASON E RICHARDS
Sworn to before me and subscribed in my presence ,
1~'-'2+~.-J3
Da te
at S. F
dA=
City and State
JAMES LARSO N
UNITED STATE S MAGISTRATE JUDG E
Name & Tit£e of Judicial Officer
Th is ;Orm was eiectr0
. y produced by El ite Federal FOm%s. GEC.
Signature of Judicial Officer
1
ATT ACHMENT A
2 1, In or about and between October 2001 and April 2002, both dates being approximate
3 and inclusive, in the Northern District of California and elsewhere, the defendant THOMAS C .
4 TRAUGER corruptly obstructed the examination of a financial institution, namely NextBank ,
S N .A., a chartered national bank and wholly owned subsidiary of NextCard, Inc ., by an agency of
6 the United States with jurisdiction to conduct an examination of such financial institution ,
7 namely the Office of the Comptroller of the Currency, in violation of 18 U .S .C . § 1317.
8 2. In or about and between January 2003 and April 2003, both dates being approximate
9 and inclusive, in the Northern District of California and elsewhere, the defendant THOMAS C .
10 TRAUGER knowingly concealed and covered up a false entry in a record, document, an d
11 tangible object, namely certain records and documents related to the annual audits and quarterly
12 reviews of the financial statements of NextCard, Inc . by Ernst and Young, LLP, with the intent to
13 impede, obstruct, and influence the investigation and proper administration of a matter within the
14 jurisdiction of any department and agency of the United States, namely the investigation o f
15 NextCard, Inc . by the Securities and Exchange Commission, in violation of 18 U .S .C . § 1519 .
16
17
i8
19
20
21
22
23
24
25
26
27
28
PROBABLE CAUSE AFFIDAVIT
(Attachment A)
1
2
ATTACHMENT B
UNITED STATES DISTRICT COURT )
3
AFFIDAVIT
NORTHERN DISTRICT OF CALIFORNIA
)
4
5
6
7
I, Jason E . Richards, being duly sworn, depose and say :
I . I am a Special Agent with the FBI and have been so employed since Septembe r
1998. l am currently investigating white collar crime, including securities fraud . Since joining
8
the FBI, I have conducted numerous investigations into various types of fraud, including money
9
10
laundering, mail fraud and wire fraud, bank fraud, bankruptcy fraud, and public corruption . In
11
addition, prior to joining the FBI, I had experience in accounting and finance. I was a certified
12
public accountant licensed to practice in the State of Maryland where I worked as a consultant .
13
As a result of my training in accountant , as well as my training as an FBI agent, I am familiar
14
15
with Generally Accepted Accounting P rinciples ("GAAP'), with Generally Accepted Auditin g
16
Standards ("GAAS"), and with various types of financial fraud , including secu ri ties fraud .
17
2 . 1 have learned the facts contained in this Complaint by, among other things ,
18
conducting interviews with current and former employees of Ernst and Young, LLP ("E&Y),
19
20
consulting with officials from the Securities and Exchange Commission ("SEC"), and conducting
21
interviews of officials from the Office of the Comptroller of the Currency ("OCC") . I have
22
reviewed sworn testimony taken by SEC officials during the course of their investigation into this
23
matter. I have also reviewed various materials, including working papers and other documents,
24
prepared by E&Y personnel and produced to the United States, both voluntarily and pursuant to
25
26
grand jury subpoenas . Some of these materials were produced in electronic form . I have also
27
reviewed various public documents, including board minutes, press releases, and filings with the
28
SEC . I have reviewed documents produced to the SEC both voluntarily and pursuant to
PROBABLE CAUSE AFFIDAVIT
(Attachment B)
1
2
administrative subpoena. No search warrant has been issued in this investigation and none of the
documents described in this Affidavit were obtained through a search warrant . Because this
3
Complaint is being submitted for the limited purpose of establishing probable cause for the
4
5
issuance of an arrest warrant for the defendant, I have included only facts relevant to that
6
determination . I have not set forth all of the facts known to me regarding the defendant's
7
unlawful conduct. Also, to the extent this Complaint contains references to statements made by
8
others, those statements are set forth only in substance and in relevant part .
9
10
11
12
A.
Relevant Entities and Parties Involved In Investigatio n
3 . At all times relevant to this Affidavit, NextCard, Inc . ("NextCard") was a
publicly-traded Delaware corporation with headquarters in San Francisco, California . Afte r
13
NextCard completed its initial public offering in 1999, the company's stock was listed on the
14
15
NASDAQ National Market . NextCard issued credit cards over the Internet through NextBank,
16
N .A, a wholly owned subsidiary and a chartered national bank regulated by the OCC . In
17
February 2002, the OCC forced NextBank to discontinue operations in light of the bank's
18
inability to raise sufficient capital to meet federal regulatory requirements and appointed the
19
Federal Deposit Insurance Corporation ("FDIC") as receiver . NextCard filed for bankruptcy in
20
21
November 2002 and is currently in liquidation . At all times relevant to this Affidavit,
22
NextCard's fiscal year ended on December 31 .
23
4 . At all times relevant to this Affidavit, Ernst and Young, LLP, was an internationa l
24
I accounting firm headquartered in New York, New York, with offices throughout the world ,
25
26
including San Francisco . E&Y was engaged as NextCard's independent auditor at all time s
27
relevant to this Affidavit and, among other things , performed annual audits and quarterly reviews
28
of NextCard's financial statements .
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 2
I
1
2
5 . The defendant THOMAS C . TRAUGER is a resident of Berkeley, California, an d
I a cert ified public accountant licensed in the State of Califo rnia . TRAUGER was the p rimary
3
E&Y audit partner assigned to the NextCard engagement at all times relevant to this Affidavit.
4
6.
5
At all times relevant to this Affidavit, Oliver Flanagan, a citizen of Republic o f
6
Ireland, worked as an auditor for E&Y and was assigned to the NextCard engagement . Flanagan
7
reported directly to TRAUGER and acted as the senior manager on the NextCard engagement at
8
all times relevant to this Affidavit. On August 14, 2003, Flanagan pled guilty to one count of
9
10
obstructing the examination of a financial institution, in violation of 18 U .S .C. § 1517 .
11
Flanagan's guilty plea is currently under seal . Flanagan is cooperating in this investigation . The
12
United States will seek to unseal Flanagan's guilty plea in the event Trauger is arrested pursuan t
13
to this criminal complaint .
14
15
B.
Surnarv of Investigatio n
16
7. My investigation has revealed that beginning in approximately October 2001 an d
17
continuing until approximately April 2002, TRAUGER and other members of E&Y's NextCard
18
engagement team destroyed, altered, and falsified both hard and electronic copies of working
19
papers related to E&Y's audit of NextCard's financial statements for its fiscal year ended
20
21
December 31, 2000, and E&Y's review ofNextCard's financial statements for its quarterly
22
reporting periods ending March 31, 2001, and June 30, 2001 . Between approximately March
23
2002 and April 2002, TRAUGER assisted in the collection and production of these altered
24
workpapers to the ©CC, pursuant to an OCC subpoena addressed to TRAUGER, dated March 1,
25
26
27
28
2001 .
8. My investigation has also revealed that, in approximately April 2003, TRAUGE R
gave swo rn testi m ony in a formal SEC investigation of NextCard and related persons an d
PROBABLE CAUSE AFFIDAVIT
( Attachment B) 3
1
2
entities . During his testimony , TRAUGER concealed his alteration and destruction of E&Y' s
working papers related to NextCard when questioned about his role in the production o f
3
documents to the OCC .
4
5
6
7
C.
Trauger's Involvement in the ACC's NextBanlt Exam
9 . Based on my interviews ofOCC officials and my review of publicly availabl e
documents, I have learned the following : The OCC is a bureau of the United States Department
8
of the Treasury which charters, regulates, and supervises all national banks and maintains a
9
10
nationwide staff of examiners which conducts on-site reviews of national banks and provides
11
sustained supervision of bank operations . Among other things, OCC examiners typically analyze
12
a bank's loan and investment portfolios, funds management, capital, earnings, liquidity ,
13
sensitivity to market risk, and compliance with consumer banking laws . The OCC began
14
15
performing regular examinations of NextBank after NextBank obtained its chart er as a nationa l
16
bank in December 1999 . In August 2001, the OCC began a comprehensive examination o f
17
NextBank .
18
10. Based on my interviews of OCC and SEC officials, I have learned that a ke y
19
indicator of the health of a bank's loan portfolio is the percentage of loans a bank writes off a s
20
21
uncollectible, often referred to as a "charge-off ratio" or a "charge-off percentage ." A loan is
22
typically charged off after a customer makes no payments for a certain period of time, often
23
180 days . Among other things, a bank's charge-off ratio is used to determine the size of its
24
allowance for loan losses -- a larger charge-off percentage suggests the need for a larger loan
25
26
loss allowance. Credit card issuers may exclude from their charge-off ratio losses attributable
27
to fraud, typically meaning unauthorized charges that occur when a customer's credit card ha s
28
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 4
1
2
been stolen or in the event of a falsified credit card application .
11 .
Based upon my discussions with SEC officials, I have learned that beginning i n
3
early 2000, NextCard began reclassifying certain categories of credit losses as fraud losses,
4
5
thereby improving the bank's charge-off ratio . Based on my review of the documents that I
6
describe below, I have learned that TRAUGER was aware of, and approved, at least one of these
7
reclassifications. I have also learned that in spite of these reclassifications, the company's
8
charge-off percentage continued to grow throughout 2000 and 2001 . The OCC's comprehensive
9
10
11
12
13
examination of NextBank focused on, among other things, NextCard's methodology for
establishing its loan loss allowance and for the securitization of its receivables .
12 . Based upon my interviews of E&Y personnel who worked with TRAUGER an d
on the documents discussed below, I have learned that TRAUGER was aware of OCC's
14
comprehensive examination of NextBank and that he assisted NextCard in addressing variou s
15
16
concerns raised by the OCC during the course of the examination . For example , I reviewed an e-
17
mail which appears to have been sent by TRAUGER to NextCard's Controller, dated October 4,
18
2001, in which TRAUGER forwarded a proposed draft of the company' s written response to
19
concerns raised by the OCC . In the e -mail, TRAUGER also offered advice on how to respond to
20
21
22
23
24
questions raised by the OCC .
13 . 1 have also reviewed TRAUGER's sworn testimony before the SEC, taken o n
April 30, 2003 . In his testimony, TRAUGER recalled attending at least one meeting with OC C
I officials relating to E&Y's review ofNextCard's financial statements for the company's third
25
26
27
28
fiscal quarter, ended September 30, 2001 .
14. According to TRAUGER 's testimony, TRAUGER learned during this meetin g
that the OCC believed that NextCard would likely experience greater loan losses in the future a s
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 5
I
a result of their issuing credit cards to customers that were increasingly less creditworthy .
2
TRAUGER also testified that he learned from the OCC -- not from NextCard - about
3
"operational decisions " made by NextCard during the third quarter that the 0CC believed woul d
4
5
result in increased loan losses at NextCard. TRAUGER testified that, while he initially
6
questioned the OCC's criticism of NextCard, he later came to believe the OCC's opinion had
1
some merit .
8
15 . Based on my interview of a junior E&Y auditor, I have learned that, i n
9
approximately October 2001, during E&Y's field work for its review of NextCard's third fisca l
10
11
quarter, TRAUGER told several members of the NextCard engagement team that the OCC had
12
challenged the sufficiency of NextCard' s allowance for loan losses as well as E&Y's audi t
13
procedures for NextCard .
14
D.
Trauger Alters A Document Produced To The OCC in October 200 1
15
16
16 . Based upon my interviews with Flanagan, I have learned the following1.7 : During
17
approximately October 2001, TRAUGER told Flanagan that the OCC had requested certain E&Y
18
working papers from its audit of NextCard's 2000 fiscal year . Flanagan told me that he believes
19
TRAUGER may have said that the OCC also requested working papers from E&Y's quarterly
20
21
reviews for NextCard's first and second fiscal quarters in 2001 . Flanagan gathered the requested
22
documents and gave them to TRAUGER for his review before their production to the OCC . In
23
Flanagan's presence and while reviewing a spreadsheet included in the 2000 audit working
24
papers concerning NextCard's securitization of loans, TRAUGER added a short handwritten note
25
26
of explanation to the top the spreadsheet . According to Flanagan, the text of TRAUGER's note
27
came from a separate memorandum that had been included in E&Y's 1999 working papers .
28
TRAUGER initialed but did not date his handwriting .
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 6
I
17. According to Flanag an , because TRAUGER had altered an original working paper
1
2
that had been carried forward and included in the working papers for subsequent reporting
3
periods , TRAUGER instructed Flanagan to photocopy his handwritt en note and to cut and paste
4
5
the text on all subsequent versions of the spreadsheet that appeared in E&Y's working papers for
6
later periods . After making these changes, on approximately October 22 , 2001, TRAUGER and
7
Flanagan personally deli vered various documents to the OCC by hand, including the altered
8
documents .
9
10
11
12
13
E.
NextCard's October 31, 2Q,01 Press Releas e
18 . Based on my review of a press release issued by NextCard dated October 31, 200 1
(the "October 31 release"), I have learned the following : On October 31, 2001, NextCard issued
a press release containing the company' s results for the third fiscal quarter, ending September 30,
14
2001 . In the October 31 release, NextCard announced, among other things, that the compan y
15
16
was significantly undercapitalized pursuant to federal banking regulations . The company also
17
announced that it had withdrawn its prior earnings guidance for all future reporting periods and
18
had hired an investment banking firm to seek opportunities for the sale of the company in light of
19
its inability to meet regulatory capital requirements .
20
21
19. In the October 31 release, NextCard also announced several significant accountin g
22
and operational changes "as a result of discussions" with the OCC and the FDIC . Among other
23
things, NextCard announced that its banking subsidiary , NextBank , would increase reserves,
24
including its allowance for loan losses , an d tighten its lending requirements . The bank would
25
26
also reclassify certain loan losses totaling $ 12 million as credit losses that had previously been
27
classified as fraud losses, including losses on certain loans sold through the bank' s securitization
28
activities .
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 7
20. As a result of these and other reclassifications required by the OCC, the bank' s
1
2
available capital decreased dramatically . The October 31 release stated that NextBank was now
3
considered "significantly undercapitalized" under applicable federal banking regulations and
4
5
would be subject to "prompt corrective action" under federal banking laws, requiring the bank to
6
submit a capital restoration plan acceptable to the OCC and to be subject to heightened
7
regulatory scrutiny.
8
21 . Based on my review of relevant trading records, I have learned that shares o f
9
10
NextCard's common stock lost approximately 80% of their value immediately following th e
11
October 31 release .
12
F.
E&Y's Document Retention Policy And AWS File s
13
22. I have reviewed a document created by E&Y which describes the firm's policies
14
15
and procedures in effect during all times relevant to this Affidavit for retaining and discardin g
16
both hard copy and electronic firm documents . In general, the policy calls for all working paper s
17
for audits, in hard copy or electronic form, to be maintained for six years . The policy also notes
18
that in the event of pending government investigations or threatened litigation, E&Y personne l
19
should consider whether working papers should be maintained beyond six years .
20
21
22
23
23 . Based on my interviews with E&Y employees, including individuals who have
developed and maintained an electronic storage system for E&Y's working papers, and my
review of documents provided by E&Y which reflect the form's policies and procedures in effect
24
during November 2001, I have learned the following : E&Y working papers include both hard
25
26
copies and electronic copies of documents . Some working papers are maintained only in
27
electronic form . E&Y maintains electronic copies of audit working papers in a database
28
developed for E&Y known as the Automated Workpaper System ("AWS") . E&Y personne l
PROBABLE CAUSE AFFIDAVIT
(Attachment B) g
I
1
frequently refer to electronically stored working papers as "AWS files ."
2
24, B ased on my review of a document produced by E&Y which describes the firm' s
3
policies and procedures in effect in November 2001 regarding AWS files, I have learned the
4
5
following : AWS files were to be "archived" at the end of an audit engagement after procedures
6
and documentation for the audit were complete . The partner in charge of the audit was to
7
authorize the final archive procedures . The archive process should have been completed within
a
approximately one month of end of the audit engagement. In the event E&Y's client filed a
9
Form 10-K with the SEC, AWS files for an audit were be archived within approximately a mont h
10
11
of the filing of the Fcrm .10-K.
25 . The document also states that, after the final archive is complete, the workin g
12
13
paper copy of the archive should be restored only when creating the next year's audit working
14
papers, when creating a copy of the archive for use by a third party, or when using the prio r
15
16
year's working papers in a subsequent audit . Most significantly, in the event that any work i s
17
necessary to complete the documentation of E&Y's procedures for the original audit year after
18
AWS files have been archived, the work must be done in hard copy, dated contemporaneously,
19
and filed in separate sections of the working paper binder for that audit .
20
21
G.
26 . Based on my review of the e-mail described below, I have learned the following :
22
23
24
Trauger Questions NextCard's Accounting Durin The OCC Exam
On November 2, 2001, another E&Y partner, who was not a member of the NextCard
engagement team but was consulted on the engagement, sent an e-mail to TRAUGER
25
26
suggesting, among other things, that E&Y begin "retrospective review procedures" to determin e
27
whether NextCard's loan loss provisions had been recorded in the correct reporting periods in
28
2001.
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 9
1
2
27 . 1 have also reviewed an e-mail which appears to have been sent by TRAUGER o n
Sunday, November 11, 2001, to several NextCard executives, including, among others, the
3
company's Chief Executive Officer, Chief Financial Officer, and Controller . In the e-mail,
4
5
TRAUGER offered various comments that were "meant to mitigate risk given the events which
6
have occurred since the press release went out ." The e-mail suggested that TRAUGER had
7
reviewed the allegations contained in lawsuits filed against NextCard as a result of the October
8
31 release . TRAUGER noted that "from our perspective, the most troubling allegations in the
9
10
shareholder suits relate to comments like the Company . .. purposely mischaracterized its true
11
loan loss levels ."' TRAUGER also noted that he had spent "a fair amount of time" with
12
NextCard's Controller discussing the issue of whether or not the change in the definition of frau d
13
losses required by the OCC would require a restatement of NextCard's financial statements from
14
prior reporting or whether the change could be handled prospectively, without a restatement .
i5
16
17
i8
28 . TRAUGER concluded the e-mail by stating, " One negative factor from my
perspective is the ever broadening definition of fraud . Until Friday, the only change I was aware
of was the Q1 2001 change made re : non-payment default . I didn't realize other changes had
19
been made ." TRAUGER copied the e-mail to Flanagan, who forwarded it to the audit manager
20
21
22
23
on the NextCard engagement (the "Audit Manager") the following day .
29. 1 have also reviewed an e-mail which appears to have been sent by TRAUGER o n
Sunday, November 11, 2001, to Flanagan asking him to collect all of E&Y's working papers
24
from the 2000 audit and from the first two quarters of 2001 relating to NextCard's allowance for
25
26
loan loss and fraud losses . TRAUGER wrote that NextCard had been "broadening its definition
27
of fraud for some time (back to Q2 2000) and the changes are material ." TRAUGER concluded,
28
"We should have picked this up ." The e-mail indicates that Flanagan forwarded the e-mail to th e
1 PROBABLE CAUSE AFFIDAVIT
(Attachment B) 10
1
C Audit Manager the next day and asked him to collect the documents that TRAUGER requested .
2
30 . Based on my review of relevant minutes from the Audit Committee of NextCard' s
3
Board of Directors, I have learned the following : The minutes of the Audit Committee meeting
4
5
for July 23, 2001, state the following : "Mr. Trauger was comfortable with the company's
6
decision to categorize first payment defaults as fraud losses ." However, based on my review of
7
TRAUGER's April 2003 SEC testimony, TRAUGER testified that he had no recollection that he
8
made this statement and, further, that he had "no recollection of fraud classification ever being
9
10
discussed" at any Audit Committee meeting that he attended .
11
H.
12
Traoger Directs Documents To Be Altere d
31 . Based on my interviews with Flanagan, I have learned the following : In
13
approximately November 2001, while the OCC examination was still ongoing , TRAUGER told
14
15
Flanagan that he wanted to review E&Y's work on NextCard 's 2000 audit in order to "beef up "
16
what was in the working papers to make it appear that E&Y was "right on the mark" all along .
17
According to Flanagan, TRAUGER told Flanagan that he wanted to go back and make sure that
18
everything in the NextCard files would not be second-guessed by "some smart-ass lawyer" in the
19
event the files were ever subpoenaed . TRAUGER asked Flanagan to come in on a Saturday in
20
21
approximately November 2001 in order to help him review the NextCard working papers .
22
TRAUGER also instructed Flanagan to research the issue of how AWS files could be modified
23
after the files had been archived in the firm's AWS database .
24
32 . Based on my review of the e-mail described below, I have learned the following :
25
26
On November 2, 2001, the Audit Manager, who reported to Flanagan, appears to have sent an e-
27
mail to Flanagan and TRAUGER regarding the modi fi cation of archived AWS files . The Audit
28
Manager's e-mail forwarded research done by a staff accountant, informing TRAUGER an d
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 11
1
2
Flanagan that after AWS files for an engagement have been archived, the copy of the archive
maintained on E&Y's nationwide server could not be modified . The research attached to the e-
3
mail reiterated E&Y's policy that any additional documentation obtained after the archive of
4
5
AWS files "should be done in hard copy and filed in a separate section of the hard copy working
6
paper file."
7
33. However, according to the e-mail, "in rare circumstances and with the approval o f
8
the engagement partner," changes may be made to AWS files maintained on a local server and
9
10
then re-archived, deleting the previously archived AWS file. Portions of the text of the e-mail
11
were bolded for emphasis. The research concluded that "in cases of re-archiving, no record will
12
be maintained of the original archive file ." In his e-mail to TRAUGER and Flanagan, the Audi t
13
Man ager wrote, "I am not sure what we want to do . The 2000 workpapers are essentially frozen.
14
15
16
17
18
I think we should discuss in person ."
34. Based on my interv iews with Flanagan, I have learned the following : TRAUGER
and Flanagan met at E&Y's offices in San Francisco on a Saturday in November 2001 in order to
alter working papers from the NextCard engagement . Flanagan used his laptop computer to
19
access AWS files stored on a local E&Y server . According to Flanagan, as TRAUGER and
20
21
Flanagan reviewed all the AWS files relating to the 2000 audit, TRAUGER directed Flanagan to
22
make various changes to working papers . Specifically, Flanagan recalls that TRAUGER directed
23
him to make changes to working papers that concerned NextCard's allowance for loan losses and
24
its securitization of receivables, among others .
25
26
35. According to Flanagan , TRAUGER also directed Flanag an to alter the date on hi s
27
laptop computer in order to give the appearance that their changes to various documents had been I
28
made at the time of E&Y's original work on the audit . After the Saturday meeting , TRAUGER
PROBABLE CAUSE AFFIDAVI T
(Attachment B)
12
1 told Flanagan that he wanted to review additional NextCard files from E&Y's 2000 audit as well
2 as working papers related to the quarterly reviews performed for NextCard in 2001 . TRAUGER
3
told Flanagan to request the Audit Manager's assistance in their effort to collect the various
4
5 documents requested by TRAUGER .
6 36 . Based on my interviews with Flanagan, I have learned the following : Soon after
7 the Saturday meeting described above, in approximately November 2001, TRAUGER, Flanagan,
a
and the Audit Manager all met on a weekday evening in E&Y's San Francisco offices .
9
10 According to Flanagan, TRAUGER, Flanagan, and the Audit Manager used the Audit Manager's
11 computer to access AWS files on a local server . The three E&Y auditors then reviewed an d
12 altered working papers from NextCard's 2001 quarterly reviews as well as working papers from
13
the 2000 audit . Flanagan told me that he explained to the Audit Manager how to change the
14
is clock on his laptop to make their alterations appear to have been made at the time of the creation
16 of the original document . During this meeting, TRAUGER reviewed the AWS files and wrote
17 down changes that he wanted made to the various documents . Among other changes, Flanagan
is told me that he recalls altering working papers concerning NextCard's allowance for loan loss
19
and NextCard's securitization of receivables . According to Flanagan, the Audit Manager typed
20
21 in the changes suggested by TRAUGER . The Audit Manager was unable to connect to E&Y's
22 network that evening in order to e-mail copies of the altered documents to Flanagan .
23 37 . 1 have reviewed an e-mail dated November 21, 2001, which appears to have been
24
sent by the Audit Manager to Flanagan, attaching copies of a Summary Review Memorandum
25
2 6 ("SRM") from the 2000 audit and a memorandum Analyzing NextCard's Loan Losses. Both of
27 these documents were originally created as part of E&Y's 2000 audit of NextCard . In the e-mail,
28 the Audit Manager wrote, "Here are the memos we discussed, sorry I could not e-mail them to
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 13
1
2
you last night." In the same e-mail, he also wrote, "Let me know when you would like to sit
down and discuss if there are other items, I would like to delete the AWS for NXCD 2000 on my
3
hard drive . Also there is a back up disk in the 2000 workpapers we should remove ."
4
5
1.
38 . Based on my interviews with Flanagan and a former E&Y auditor, as well as my I
6
7
Trauger Directs Meeting with Former E&Y Auditor
review of relevant documents, I have learned that in approximately November 2001, TRAUGER
8
directed Flanagan to meet with a former member of NextCard's engagement team as part of their
9
10
effort to alter one of E&Y's working papers . The former auditor acted as a manager on the 2000
11
NextCard audit and left the firm in approximately April 2001 . According to Flanagan, he met
12
with the former E&Y auditor outside E&Y's offices in order for her to copy handwritten note s
13
that she had originally written on a securitization working paper into a new version of the same
14
15
document that had been altered by TRAUGER. According to the former E&Y auditor, Flanagan
16
her that TRAUGER said that these actions were appropriate because the working paper was
17
simply being "recreated ."
18
1.
Trauger Directs Document Destruction After OCC Subpoena and SEC Inquiry
19
39. As noted above, in February 2002, the OCC forced NextBank to discontinu e
20
21
operations in light of the bank ' s inabili ty to raise sufficient capital to meet federal regulato ry
22
requirements and appointed the FDIC as receiver . Based on my interviews with Flanagan and
23
my review of the relevant documents described below, I have learned the following : On March
24
1, 2002, the OCC sent a subpoena to TRAUGER concerning NextCard that called for the
25
26
production of documents relating to NextCard. The OCC subpoena, sent to E&Y care of
27
TR.AUGER, specifically requests that E&Y list any responsive documents that were previously
28
destroyed and explain the reasons for the destruction of the documents .
PROB ABLE CAUSE AFFIDAVIT
(Attachment B) 14
40 . On March 5, 2002, the San Francisco office of the SEC sent a letter to an E& Y
1
2
attorney informing the firm that the SEC was conducting an investigation of NextCard an d
3
asking E&Y to preserve certain documents, including all working papers prepared in connectio n
4
5
with E&Y's audit work for NextCard in 1999, 2000, and 2001 . On March 15, 2002, TRAUGER
6
appears to have sent a letter to members of the NextCard engagement team, including Flanagan
7
and the Audit Manager, informing them of the OCC subpoena and the SEC request to preserve
8
NextCard documents . In the letter, TRAUGER stated that "the scope of the subpoena is very
9
10
broad and includes all workpapers, desk/person files, and emails in your possession ."
41 . Based on my interviews with Flanagan , I have lea rn ed that soon after E&Y
11
12
13
received the OCC subpoena, TRAUGER asked Flanagan to collect various NextCard document s
in order to respond to the subpoena . TRAUGER also told Flanagan to destroy all e-mails or
14
documents on his computer that related to the altered NextCard working papers . Flanagan told
is
16
me that he deleted at least two e-mails concerning the alterations . Flanagan later found a
17
computer disk belonging to the former NextCardaudit manager that was plainly labeled as
18
containing material related to NextCard . Flanagan gave the disk to TRAUGER. After looking at
19
the disk, TRAUGER told Flanagan to destroy it . Flanagan, without telling TRAUGER, kept the
20
21
disk and has provided a copy to the government . I have reviewed this disk and confirmed that,
22
among other things, the disk contains NextCard materials prepared during the course of the 2000
23
audit .
24
25
26
K.
Altered Documents Are Produced to the OCC in 2002
42 . Based on my review of relevant documents , and interviews with OCC and SEC
27
officials, I have learned the following : On April 5, 2002, E&Y produced documents in respons e
28
to the OCC subpoena dated March 1, 2002 . As explained more fully below, I believe that E& Y
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 15
1
produced documents to the OCC that had been altered or destroyed by TRAUGER, Flanagan,
2
and the Audit Manager.
3
L.
Altered Documents Are Produced to the SEC in 200 3
4
5
43 . Based on my interview of the former E&Y auditor who acted as the NextCard
6
audit manager, I have learned the following : In approximately January or February 2003,
7
TRAUGER telephoned the former NextCard audit manager and asked her to meet him at E&Y's
8
offices in San Francisco . During this meeting, TRAUGER showed the former auditor NextCard
9
10
working papers, including working papers related to NextCard's loan loss allowance and the
11
company's securitization of loans . According to the former auditor, TRAUGER said that he had
12
to explain some of the documents to E&Y's attorneys . TRAUGER became angry when the
13
former E&Y auditor was not able to identify or explain one of the documents that TRAUGER
14
said she had w ritt en, which she did not recall . TRAUGER also told the former auditor that h e
15
1.6
17
18
had a meeting scheduled with the SEC .
44 . Based upon my interview of an in-house attorney for E&Y and my discussion s
with SEC officials, I have learned the following : In connection with the SEC's investigation of
19
NextCard, E&Y personnel voluntarily met with SEC officials at the SEC's San Francisco offices
20
21
in approximately January 2003 . At the meeting, E&Y distributed binders containing certain
22
NextCard working papers for discussion purposes . SEC officials have informed me that these
23
binders contain at least some of the altered documents that were previously produced to the
24
OCC . According to SEC officials, TRAUGER attended this meeting and was present at the time
25
26
the altered working papers were distributed to the SEC officials-
27
45 . Based upon my review of the relevant documents described below, and my
28
discussions with SEC officials, I have learned the following : On April 21, 2003, the SEC sent a
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 16
I
1
2
subpoena to TRAUGER requiring him to appear for investigative testimony and to produce
certain documents relating to NextCard . Prior to the date ofTRAUGER's subpoena, SEC
3
officials and counsel for E&Y reached an agreement that documents produced by E&Y to the
4
5
OCC need not be produced again to the SEC, as the SEC could obtain the documents directly
6
from the OCC . Based upon my conversations with SEC officials, I have learned that the SEC
obtained documents from the OCC that were altered by TRAUGER . I have described below my
8
basis for believing that specific alterations were made to documents that were produced to the
9
10
OCC and the SEC.
46 . On April 30, 2003, TRAUGER appeared for SEC testimony and, while unde r
11
12
I oath, described the steps that he took in 2002 to comply with the OCC subpoena to E&Y.
13
Among other things, TRAUGER testified that he undertook an "extensive" search for responsive
14
15
documents . TRAUGER also testified that he "walked the halls for the people in San Francisco "
16
to make sure that all responsive documents were collected in response to the OCC subpoena .
17
TRAUGER concealed his destruction of documents in response to, or in anticipation of, the OCC
18
subpoena.
19
M.
Trauger Admits Altering Working Paper s
20
21
47 . In approximately June 2003, TRAUGER was interviewed by attorneys for E& Y
22
as part of the firm's internal investigation into the possible alteration of NextCard working
23
papers . I have interviewed an E&Y in-house attorney who participated in the interview of
24
TRAUGER . Based upon my interview with this attorney, I have learned that TRAUGER
25
26
admitted to the attorney that he made changes to certain NextCard working papers after the
27
documents had been finalized . According the E&Y attorney, TRAUGER also attempted to
28
minimize the significance of the changes he made to E&Y's working papers .
PROBABLE CAUSE AFFIDAVI T
(Attachment B)
17
I
1
2
I M.
Specific Alterations In Documents Produced to Governmen t
48 . Based on my interviews of E&Y personnel with knowledge of the firm's AW S
3
database and its information systems, including an individual who maintains the AWS database,
4
5
my interviews of OCC personnel, and my review of relevant documents, including electronic
6
documents and AWS files, as described below, I have learned the following : E&Y has no record
7
of NextCard's 2000 audit working papers being archived in the firm's AWS database until
8
November 26, 2001, over seven months after NextCard's Form 10-K for its 2000 fiscal year was
9
10
filed with the SEC on April 2, 2001 . E&Y's policy, as explained above, would have required the
11
NextCard AWS files for the 2000 audit to be archived by approximately May 2001, one month
12
after NextCard's Form 10-K was filed .
13
49 . One junior E&Y auditor assigned to the NextCard engagement told me that she
14
1S
recalls archiving AWS files for the 2000 audit, along with AWS files for the 1999 audit ,
16
sometime in the summer of 2001 . However , as noted above , E&Y has no record of AWS files
17
for the 2000 audit being archived until November 26, 2001, and the firm has no record of the
18
1999 NextCard audit ever being archived . Based upon my interviews with Flanagan, I believe
19
that the AWS files archived on November 26, 2001, had been altered by TRAUGER, Fl an agan,
20
21
22
23
and the Audit Manager during November 2001 .
50 . Based on my review of a summary and analysis of documents provided tome b y
E&Y, and E&Y personnel who prepared the summary and analysis of those documents, I have
24
learned that, on July 19, 2001, a copy the AWS files for E&Y's 2000 NextCard audit was saved
25
26
onto the hard drive of the laptop computer of a junior member of E&Y's NextCard audit team . I
27
have interviewed the junior auditor, who told me that, although he does not recall copying the
28
AWS files onto his laptop, he may have obtained the AWS files for the 2000 audit either becaus e
PROBABLE CAUSE AFFIDAVIT
(Attachment B)
18
1
he needed the documents to assist in the quarterly review for NextCard's quarter ended June 30 ,
2
2001, or because he was responsible for "migrating " the AWS files of several clients, including
3
NextCard, into a new software program during the summer of 2001 .
4
51 .
5
Based on my interview of the junior auditor, I believe that the AWS files save d
6
onto the junior auditor's laptop computer in July 2001 are copies of the original AWS files from
7
E&Y's 2000 audit that existed at the completion oftlthe engagement . I have compared versions of
8
9
10
documents contained in the July 2001 AWS files found on the laptop computer with versions of
the same documents contained in the AWS files that were archived on November 26, 2001, and
later produced to the OCC and the SEC .
12
13
52 . As explained below, I have found significant differences in several documents ,
including , but not limited to, the following : (i) a memorandum dated December 31, 2000,
14
containing an analysis of NextCard' s loan loss allowance (the "2000 Loan Loss Memo") ; (ii) the
15
16
Summary Review Memorandum for NextCard's 2000 Audit, dated December 31, 2000 (the
17
"2000 SRM") ; and (iii) a memorandum describing NextCard's securitization of credit card
18
receivables, dated September 30, 2000 (the 'Third Quarter 2000 Securitization Memo") .
19
N.
The 2000 Loan Loss Mem o
20
53 . The following cha rt compares the July 2001 version of the 2000 Loan Loss Memo
21
22
with the version that was archived on November 26, 2001, and later produced to the OCC and
23
the SEC. This chart is derived from my review of a summary and analysis of documents
24
provided to me by E&Y . I have added italics in order to illustrate some of the differences in the
25
26
two versions .
27
Ill
28
Il
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 19
1
"We have noted that the Company's average
"We have noted that the Company's averag e
receivable life is approximately 8 months .
However, the lagged coverage periods as of
receivable life is approximately seven
months. As such, the lagged coverage
year-end 2000 are less than the expected life
periods as of year-end 2000 are equal to th e
of the receivables . Per discussion with the
expected life of the receivables . In addition ,
client, the short coverage periods are
conservative given the fact that the client
expects to securitize most of its loans in
2001 ."
the Company has told us they plan t o
securitize approximately $300 millio n
receivables in the first quarter of 2001 (i .e. no
allowance would be needed to 'cover month s
after March 2001) . The Company als o
expects that their new collections process wil l
increase their number of recoveries beginnin g
in Q1 2001 ."
10
"We have discussed with the client the fact
that given the nature of the economy, ther e
Delete d
11
will need to be close monitoring in the 1 1
12
quarter 2001 to ensure that the reserv e
amounts are reasonable given shifts in th e
economy . Furthermore, since the client ha s
2
3
4
5
6
7
8
9
13
14
I5
16
17
reduced its roll rate percentages based on it s
implementation of rigorous collectio n
policies, the impact of these policies will need
to be checked at first quarter 2001 to ensur e
that these policies are effective and to assess
if the client's loan loss reserve analysi s
requires further adjustments.
18
19
54. In addition to the deletions and changes noted above, the version of the 200 0
20
Loan Loss Memo produced to the OCC contains additional inform ation, including new charts ,
21
that was not included in the July 2001 version .
22
23 10.
The 2000 SRM
24
55.
25
The following chart compares the July 2001 version of the 2000 SRM with th e
version that was archived on November 26, 2001 , and later produced to the OCC and the SEC .
26
This chart is derived from my review of a summary and analysis of documents provided to me b y
27
.
28 [ E&Y . I have added italics in order to illustrate some of the differences in the two versions
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 21
1
2
3
4
5
6
9
1 July 2001 Version I Version Produced to OCC/SEC 11
"Industry practice with respect to DAC
[deferred acquisition costs) upon sale is
mixed. However, most companies offset
these amounts against the gain on sale. As o f
December 31, 2000, no amounts were backed
out of deferred acquisition costs for
securitized loans . We performed an analysis
of the impact of these potential adjustments
and noted that the amounts were immaterial
to the financial statements. However, going
forward the client will reverse these amounts
as it securitizes its portfolio. "
"There is diversity in practice in the industry
with respect to the treatment of DAC upon
securitization of balances with som e
companies offsetting these amounts against
the gain on sale . The Company like most of
its peers continues to account for DAC
subsequent to securitization as only customer
balances vs the relationship is sold in a
securitization. This is supported by EITF 925andFAS9I ."
"consistent practice among most other
companies in the credit card industry is to
remove all capitalized debt issuance costs
related to off-balance sheet securitizations,
upon recognition of the gain on sale . (Bank
One does not follow this practice .)
Deleted
"NextCard has retained all capitalized debt
issuance costs for its securitizations on its
balance sheet. Some contend that since the
receivables and the corresponding debt
facility for the receivables are sold and
transferred of balance sheet, the related
capitalization of prepaid debt issuance costs
should also be taken off the balance sheet and
included as part of the transaction cost of the
securitization. "
[The first block of text remains unaltered ]
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
"Others however, contend that on a
theoretical basis the Company will still obtain
benefits from the securitized portfolio in
terms of recognizing replenishment gains
throughout the life of the securitization, and
therefore that the costs of the facility are still
associated with the ongoing benefits to the
client. We have accepted the client's position
that the capitalized debt issuance costs have
ongoing benefits and these are properly stated
at 12/31/00 . We have indicated to the client
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 22
[The second block of text is deleted and the
following text is substituted in its place : ]
"GAAP, however, provides that these costs
should be capitalized on a theoretical basis as
the Company will still obtain benefits from
the securitized portfolio in terms of
recognizing replenishment gains throughout
the life of the securitization, and therefore
that the costs of the facility are still associated
with ongoing benefits to the client . We
concur with the client's position that the
capitalized debt issuance costs have ongoing
benefits and are properly stated at 12/31/00 ."
1
2
that their practice is not consistent with the
majority ofits industry peers.
3
4
P.
The ThirdOuarter 2000 Securitization Mem o
5
56 . The following chart compares the July 2001 version of the Third Quarter 2000
6
7
Securitization Memo with the version that was archived on November 26, 2001, and late r
8
produced to the OCC and the SEC . This chart is derived from my review of a summary an d
9
analysis of documents provided to me by E&Y . I have added italics in order to illustrate some
10
of the differences in the two versions .
I1'
12
July 2000 Version
13
Under heading listing securitization issues to
14
Version Produced to 4CC/SEC
Deleted
be addressed during year-end audit for 2000 :
is
17
"Due to new requirements under FAS 140 ,
the Company will need to make certai n
disclosures in the footnotes (such as a
18
statements ."
19
Under heading listing securitization issues to
be addressed during year-end audit for 2000 :
16
sensitivity analysis) to its financia l
Deleted
20
21
"Review and assessment of reasonableness o f
accounting for new term trust including the
22
assumptions used ."
23
24
Under heading listing securitization issues to
be addressed during year-end audit for 2000 :
25
"Reversal of deferred acquisition costs pe r
FAS 91 for receivables in the trust that hav e
26
been sold through securitizations."
27
28
PROBABLE CAUSE AFFIDAVI T
(Attachment 13) 23
Deleted
1
2
3
4
5
6
7
Under beading listing securitization issues to Deleted
be addressed during year-end audit for 2000 :
"Reversal of capitalized transaction costs for
facilities that are taken off the balance sheet
in relation to securitized loans."
One paragraph section with heading Deleted
"Reversal of Deferred Acquisition Costs ."
Two paragraph section with heading Deleted
"Reversal of Capitalized Transaction Costs ."
8
9
10
57 . As a result of these and other deletions, the version of the Third Quarter 200 0
11
12
13
Securitization Memo that was produced to the 0CC was less than half the length of the July 200 1
version . Further, a four-page memorandum entitled "Securitization Accounting" was produced
14
to the OCC and is included in the AWS files archived on November 26, 2001 . This
15
16
memorandum purports to have been "prepared during the course of second quarter review
17
procedures for NextCard" and was "included in our year-end workpapers as a source of
18
reference." This memo, purportedly created in mid-2000, does not appear in the AWS files
19
saved in July 2001 and recovered from the junior auditor's laptop .
20
21
Q.
Other Changes to 2000 Audit Working Paper s
58 . In addition to the changes desc ribed above, my comparison of the July 2001 AW S
22
23 I files with the AWS files produced to the 0CC and the SEC revealed alterations in additiona l
24
working papers for the 2000 NextCard audit, including a memorandum regarding Financial
25
Accounting Standards Bulletin ("FASB') 91, a debt issuance spreadsheet, and a consultatio n
26
27
1 memorandum.
28
1 I!
PROBABLE CAUSE AFFIDAVIT
(Attachment B) 24
I
1 R
.
Alterations In 2001 Summary Review Memoranda Produced to OCC
2 59 . Based on my interviews with E&Y personnel, members of the SEC's enforcement
3
staff, and OCC personnel involved in the OCC's examination of NextBank, and my review of the
4
relevant documents described below, I believe that documents related to E&Y's reviews o f
6 NextCard's first and second fiscal quarters in 2001 were also altered prior to their production to
7 the OCC.
8
60 . I have reviewed an e-mail sent on October 25, 2001, to TRAUGER and the Audit
9
10 Manager by a junior E&Y auditor on the NextCard engagement, attaching E&Y SRMs for
11 NextCard's 2001 first and second quarter reviews . The second quarter SRM begins with the
12 following notation: "Highlighted and bolded text refers to Tom Trauger's questions ."
13
14
15
Throughout the document, questions and comments appear in text that has been bolded and
%
highlighted . The junior auditor recalls that he added this text at TRAUGER's request but made
16 no other changes to the document before forwarding it to TRAUGER and the Audit Manager .
17 61 . I have compared the SRMs attached to the October 25 email with versions of the
18 same SRMs recovered by E&Y from the Audit Manager's computer which were last revised in
19
20 February 2002 . The versions of the SRMs found on the Audit Manager's computer are identical
21 to the first and second quarter SRMs that were produced to the OCC and the SEC .
22 S .
TheOl 2001 SRM
23 62 . The following chart compares the SRM for the first quarter of 2001 which was
24
attached to the October 25, 2001 email with the version recovered from the Audit Manager's
25
2 5 computer which was last revised in February 2002 and later produced to the OCC . This chart is
2 -7 derived from my review of a summary and analysis of documents provided to me by E&Y . I
28 have added italics in order to illustrate some of the differences in the two versions .
PROBABLE CAUSE AFFIDAVI T
(Attachment B) 25
1
2
3
October 25, 2001 Version
Version Produced to OCC/SE C
In the "Allowance for Loan Losses" portion
In
In the same table, the recovery rate i s
of the SRM, a table contains the followin g
characterized as:
characterization of the Company' s
4
assumptions for its loan recovery rate:
5
"Aggressive °'
"Conservative "
"Per review of the different scenarios being
Deleted
6
7
8
9
10
11
12
used for the reserve analysis, we have note d
that the Company remains at the low end of
the acceptable range for its reserves ."
"There were several off balance sheet
securitizations that took place in the 11
There were several off-balance shee t
securitizations that took place in the 1 g
quarter as indicated above . Many of the
quarter as indicated above . The gain on the
client's assumptions changed in booking the
gain on these securitizations . The include the
following :"
sale/interest only strip of the valuation
assumptions used by the Company were as
follows :
13
[A column in table was deleted whic h
reflected certain assumptions regarding
NextCard's loan securitization at 12/31100 .]
14
15
16
17
T.
The 02 2001 SRM
18
63. 1 have also compared the SRM for the second quarter of 2001 which was attached
19
20
21
22
~ to the October 25 email with the version recovered from the Audit Manager's computer whic h
was last revised in February 2002 and later produced to the OCC . In general, the version
produced to the OCC and recovered from the Audit Manager's computer appears to hav e
23
incorporated the comments and suggestions made by TRAUGER that were bolded and
24
25
highlighted in the version of the SRM attached to the October 25 email . The section titled
26 I "Allowance for Loan Losses," was revised significantly .
27
1/
28
PROBABLE CAUSE AFFIDAVIT
26
(Attachment B)
1 U.
The Counts Charged in the Criminal Complain t
2 64, Based on the facts set forth above, as applied to the applicable law, I believe there
3
is probable cause to conclude that THOMAS C . TRAUGER committed one count of obstructing
4
5 the examination of a financial institution in violation of 18 U .S.C . § 1517 and one count o f
6 falsification of records in a federal investigation in violation of 18 U .S.C. § 1519 . As a result,1
7 am seeking a criminal complaint that charges TRAUGER with the following two counts :
8
(a) COUNT ONE : The United States charges that, in or about and between October
9
10 2001 and April 2002, both dates being approximate and inclusive, in the Northern
11 District of California and elsewhere, THOMAS C . TRAUGER corruptl y
12 obstructed and attempted to obstruct the examination of a financial institution,
13
namely NextBank, N .A ., a chartered national bank and wholly owned subsidiary
14
15 of NextCard, Inc ., by an agency of the United States with jurisdiction to conduct
16 an examination of such financial institution, namely the Office of the Comptroller
-' of the Currency, in violation of 18 U .S .C. § 1517 .
18 (b) COUNT TWO : The United States charges that, in or about and between January
19
20 2003 and April 2003, both dates being approximate and inclusive, in the Northern
21 District of California and elsewhere, THOMAS C . TRAUGER knowingl y
22 concealed and covered up a false entry in a record, document, and tangible object,
23 namely certain records and documents related to the annual audits and quarterly
24
reviews of the financial statements ofNextCard, Inc . by Ernst and Young, LLP,
25
26
Il
27 Il
28 1!
PROBABLE CAUSE AFT: IDAVIT
(Attachment
B)
27
with the intent to impede, obstruct, and influence the investigation and proper
1
2
administration of a matter within thejurisdiction of any department and agency of
3
the United States, namely the Securities and Exchange Commission, in violation
4
of 18 U.S.C. § 1519 .
5
6
7
8
Dated:
4110
9
10
JAS E . RICHARI}S
Sped Agent
Federal Bureau of Investigatio n
11
12
13
14
15
Subscribed and sworn to before me
this lV' ...day of September 2003 .
16
17
INC
"I-010 --.~ .~
S LARSON
United States Magistrate Judg e
16
19
20
21
22
23
24
25
26
27
28
PROBABLE CAUSE AFFIDAVIT
(Attachment B)
28
Exhibit 4
i
Thomas C. Trauger and Michael Mullen : Admin . Proc . Rel. No. 34-48543 / September 25 ... Page 1 of 2
Home € Previous Pag e
UNITED STATES SECURITIES AND EXCHANGE
COMMISSIO N
SECURITIES EXCHANGE ACT OF 1934
Release No . 48543 / September 25, 200 3
ACCOUNTING AND AUDITING ENFORCEMENT
Release No . 1872 / September 25, 200 3
ADMINISTRATIVE PROCEEDING
File No . 3-1127 0
COMMISSION ISSUES ORDERS ALLEGING THAT AUDITORS
VIOLATED RULES OF PRACTICE BY ALTERING AND DELETING AUDIT
WORKING PAPERS
The Commission announced today that it has instituted administrative
proceedings against Thomas C . Trauger , a former audit partner with Ernst
& Young, LLC ("E&Y"), and Michael Mullen , an E&Y audit manager .
The Order Instituting Public Administrative Proceedings Pursuant to Rule
102(e) of the Commission's Rules of Practice ("Order") alleges that
Trauger, assisted by Mullen and a third senior manager, altered E&Y's
working papers for the fiscal year 2000 audit of E&Y client NextCard, Inc .
The alterations and deletions were made months after the audit had been
completed and the working papers had been signed and archived . NextCard
was a publicly-traded, San Francisco-based issuer of credit cards over the
Internet . The Order alleges that Trauger directed Mullen to make changes
to the NextCard working papers and delete information from them . He also
instructed another senior manager to destroy documents inconsistent with
the changes he was directing, and the senior manager complied in part .
The alterations and deletions made it appear as though E&Y had thoroughly
considered all of the appropriate issues and available facts relating to
NextCard's allowance for loan losses ("allowance") and NextCard's
securitization of receivables . The Order further alleges that the alterations
and deletions were in response to the October 2001 announcement by
NextCard that the Office of the Comptroller of the Currency ("OCC") and
Federal Deposit Insurance Corporation ("FDIC") were requiring NextCard's
bank subsidiary, NextBank, to revise certain accounting treatments
affecting the allowance and securitizations, After altering the working
papers, Trauger, Mullen and the senior manager provided the altered
documents to E&Y's legal department for production in response to a
subpoena from the OCC and later subpoenas from the FDIC and SEC .
A hearing will be scheduled before an Administrative Law Judge to
determine whether the allegations in the Order are true, to provide
respondents an opportunity to dispute the allegations, and to determin e
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9/2512Of Y
Thomas C. Trauger and Michael Mullen : Admin . Proc . Rel . No. 34-48543 / September 25 . .. Page 2 of 2
what, if any, remedial action is necessary and appropriate against Trauger
and Mullen pursuant to Rule 102(e) of the Commission's Rules of Practice .
The Commission directed that an Administrative Law Judge should issue an
initial decision in this matter within 300 days from the date of service of the
Order .
http ://www.sec.gov/litigation/admin/34-48543 .htm
Home I Previous Page Modified : 09125/2003
http://lvwly.sec .gov/litigationfadmin/34-48543 .htm 9/25/2003
ti. .
Exhibit 5
i
Oliver Flanagan : Admin. Proe . Rel. No . 34-48542 / September 25, 2003
Page 1 of 6
Home I Previous Pag e
un[Veu aWL"-5 of Americ a
before the
Securities and Exchange Commission
Securities Exchange Act of 193 4
Release No . 48542 / September 25, 200 3
Accounting and Auditing Enforcement
Release No . 1871 / September 25, 2€0 3
Administrative Proceeding
File No . 3-1126 9
In the Matter of
ORDER INSTITUTING PUBLI C
PROCEEDINGS PURSUANT
O LIVER FLANAGAN, ADMINISTRATIVE
TO RULE 102(e) OF THE COMMISSION'S
Cha rt ered Accountant
RULES OF PRACTICE, MAKING FINDINGS, AND
IMPOSING REMEDIAL SANCTIONS
Respondent . :
1.
The Securities and Exchange Commission ("Commission") deems it
appropriate that public administrative proceedings be, and hereby are,
instituted against Oliver Flanagan, Chartered Accountant, ("Respondent" or
"Flanagan") pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of
Practice .II .
In anticipation of the institution of these proceedings, Respondent has
submitted an Offer of Settlement (the "Offer") which the Commission has
determined to accept . Solely for the purpose of these proceedings and any
other proceedings brought by or on behalf of the Commission, or to which
the Commission is a party, and without admitting or denying the findings
herein, except as to the Commission's jurisdiction over him and the subject
matter of these proceedings, which are admitted, Respondent consents to
the entry of this Order Instituting Public Administrative Proceedings
Pursuant to Rule 102(e) of the Commission's Rules of Practice, Making
Findings, and Imposing Remedial Sanctions ("Order"), as set forth below .
Ill .
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Oliver Flanagan : Admin . Proc Rel . No. 34-48542 f September 25, 2001 Page 2 of 6
On the basis of this Order and Respondent's Offer, the Commission finds?
that :
A. Respondent
Oliver Flanagan, 34, is a resident of Ireland, and has been a Chartered
Accountant since 1996 . Flanagan worked for Ernst & Young ("E&Y")
between July 1997 and April 1999 in their Luton, England and London,
England offices . After a brief period working for a bank, Flanagan rejoined
E&Y in April 2000 and worked in E&Y's San Francisco, California office until
early 2002 . During this period, Flanagan was a member of the audit team
for NextCard, Inc . ("NextCard") . Beginning in early 2002, Flanagan worked
for Ernst & Young Chartered Accountants, in Dublin, Ireland . Flanagan
resigned from Ernst & Young Chartered Accountants in 2003 .
B . Other Relevant Person s
1 . The "Audit Partner" became the audit partner responsible for E&Y'S
NextCard audits in October 2000 and was at all relevant times after that
date the E&Y partner in charge of the audit team for NextCard .
2 . The "Other Audit Manager" was another E&Y employee who worked on
the NextCard audit team beginning in mid-2001 .
C . Facts
1 . NextCard was an internet-based credit card issuer located in San
Francisco, California and incorporated in Delaware . During the relevant
period, NextCard's stock was registered with the Commission pursuant to
Section 12(g) of the Exchange Act and was listed on the NASDAQ National
Market .
2 . NextCard wholly owned NextBank, N .A ., a chartered bank that funded
the credit card loans . NextBank was subject to regulation by the Office of
the Comptroller of the Currency .
3 . NextCard retained E&Y to audit its financial statements for the year
ended December 31, 2000 (the "2000 audit") . The Audit Partner was
assigned to head the engagement . Flanagan was assigned to the audit as
senior manager . Acting at the Audit Partner's direction, E&Y accountants
conducted an audit of NextCard's financial statements in December 2000
and January 2001 . The fact gathering phase of this work, known as "field
work," was memorialized in documents called "working papers ." On or
about March 14, 2001, the Audit Partner and Flanagan reviewed some or all
of the working papers and the Audit Partner approved E&Y's issuance of an
auditor's report containing an unqualified opinion on NextCard's financial
statements . E&Y's report was dated January 23, 2001, the date that E&Y's
field work was concluded . The Other Audit Manager joined the NextCard
audit team as a manager in approximately June 2001 during additional E&Y
work .
4 . In the summer of 2001, the Office of the Comptroller of the Currency
asked E&Y for a portion of its audit working papers regarding E&Y's audit of
NextCard . The Audit Partner was notified of this request .
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o1, r' I'M n 11
Oliver Flanagan : Admin . Proc 'z .el. No. 34-48542 September 25, 200" Page 3 of 6
5 . On October 31, 2001, NextCard announced in a press release that the
Office of the Comptroller of the Currency had asked the company to make
certain changes regarding NextBank's accounting practices, including
changes regarding the classification of losses on credit cards . The company
also announced that it intended to sell NextBank because it was unable to
raise sufficient capital to meet bank regulatory requirements after, among
other issues, the office of the Comptroller of the Currency called for
NextBank to reclassify certain losses .
6. Following the company's press release on October 31, 2001, the trading
price of its common stock declined by approximately 84 percent .
7 . In the first few days of November 2001, the Audit Partner became
concerned that E&Y's audit work would be examined by regulatory agencies
or others . The Audit Partner instructed Flanagan to gather together the
working papers for the NextCard 2000 audit (both hard copy files and those
electronically archived) and have them ready for revisions during a
Saturday meeting .
8. Also at this time, the Audit Partner began to investigate how to
manipulate E&Y's computer system so that he could alter electronically
archived working papers without being discovered . The Audit Partner asked
the Other Audit Manager to find out how to de-archive an audit in order to
revise and re-archive the working papers . On or about November 2, 2001,
the Other Audit Manager obtained information on this subject from another
E&Y employee and forwarded that information to the Audit Partner and
Flanagan .
9 . On a Saturday in November 2001, the Audit Partner and Flanagan met in
E&Y's San Francisco office and altered portions of E&Y's electronic working
papers for the NextCard 2000 audit, These alterations consisted of both
additions and deletions to the working papers . Specifically, the Audit
Partner altered the Summary Review Memorandum ("SRM") as well as
memoranda regarding the audit of NextCard's allowance for loan and lease
losses and securitizations of receivables . The Audit Partner marked up
printed versions of the documents and gave them to Flanagan for Flanagan
to input using Flanagan's laptop computer . In order to ensure that the
revised documents appeared to have been created as part of the original
working papers, the Audit Partner instructed Flanagan to reset the date on
his computer so that any documents bearing computer-generated dates
would reflect a date in early 2001 . Some documents went through more
than one edit, as Flanagan input the Audit Partner's changes and then
printed out the revised version for the Audit Partner's further review .
10 . Later in November 2001, the Audit Partner asked Flanagan and the
Other Audit Manager to assist him in making additional alterations to the
working papers for the NextCard 2000 audit . The Audit Partner, Flanagan
and the Other Audit Manager met and made additional alterations to these
working papers, using the Other Audit Manager's laptop computer .
Flanagan showed the Other Audit Manager how to change the date setting
on his computer to make it appear as though the altered workpapers were
created earlier in the year at the time the original audit work had been
performed . The Audit Partner marked up printed versions of the
memoranda he was revising and then the Other Audit Manager input the
changes . At the Audit Partner's direction, the Other Audit Manager delete d
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Oliver Flanagan: Admin . Proc . 'el . No . 34-48542 / September 25, 2003 Page 4 of 6
charts, portions of tables, and discussion sections that indicated problems
with NextCard's charge-off numbers and trends . The Audit Partner also
added information and altered the tone of certain sections . One of the
documents altered during this meeting was a memorandum entitled
"Analysis for Loan Losses ." Flanagan remained involved in the process by
proofreading the Other Audit Manager's work to ensure that all of the Audit
Partner's changes were made .
11 . The Audit Partner's purpose in altering E&Y's working papers was to
make it appear that there was a more satisfactory basis for E&Y's audit
conclusions .
12. In or about November 2001, after altering the working papers, the
Audit Partner instructed Flanagan to scour his hard drive and delete
documents or emails inconsistent with the altered versions of the working
papers . Flanagan complied and deleted documents .
D . VIOLATIO N
13 . As a result of the conduct described above, Flanagan engaged in
unethical and improper professional conduct by engaging in intentional or
knowing conduct, including reckless conduct, that resulted in a violation of
applicable professional standards . He violated professional auditing
standards governing the creation and retention of working papers as well as
those establishing the standards for ethical conduct by auditors .
Statements on Auditing Standards are cited in the "AU" section of the
AICPA's Professional Standards . AU Section 339 addresses the preparation
and maintenance of working papers . AU 339 .01 states that the information
contained in working papers constitutes the principal record of the work
that the auditor has done and the conclusions he has reached concerning
significant matters . AU 339 .08 requires the auditor to "adopt reasonable
procedures for safe custody of his working papers and retain them for a
period sufficient to satisfy any pertinent legal requirements of records
retention ." The AICPA Code of Professional Conduct, specifically ET Sections
51-54 and 56, provides additional professional standards for auditors .
These sections require a high level of professional ethics and integrity from
public accountants . Flanagan's intentional alteration and destruction of
portions of the working papers for the NextCard 2000 audit violated these
professional standards .
IV .
In view of the foregoing, the Commission deems it appropriate to impose
the sanctions agreed to in Respondent Flanagan's Offer .
Accordingly, it is hereby ORDERED, effective immediately, that :
A . Flanagan is denied the privilege of appearing or practicing before the
Commission .
B . After three (3) years from the date of this order, Respondent may
request that the Commission consider his reinstatement by submitting an
application (attention : Office of the Chief Accountant) to resume appearing
or practicing before the Commission as :
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Oliver Flanagan : Admin . Proc . Rel. No. 34-48542 / September 25, 2003 Page 5 of 6
1 . a preparer or reviewer, or a person responsible for the preparation or
review, of any public company's financial statements that are filed with the
Commission . Such an application must satisfy the Commission that
Respondent's work in his practice before the Commission will be reviewed
either by the independent audit committee of the public company for which
he works or in some other acceptable manner, as long as he practices
before the Commission in this capacity ; and/o r
2. an independent accountant . Such an application must satisfy the
Commission that :
(a) . Respondent, or the firm with which he is associated, is a member of
the SEC Practice Section of the American Institute of Certified Public
Accountants Division for CPA Firms ("SEC Practice Section") or an
organization providing equivalent oversight and quality control functions
("equivalent organization") ;
(b) . Respondent, or the firm, has received an unqualified report relating to
his, or the firm's, most recent peer review conducted in accordance with
the guidelines adopted by the SEC Practice Section or equivalent
organization ; an d
(c) . As long as Respondent appears or practices before the Commission as
an independent accountant he will remain either a member of, or
associated with a member firm of, the SEC Practice Section or equivalent
organization, and will comply with all applicable SEC Practice Section or
equivalent organization requirements, including all requirements for
periodic peer reviews, concurring partner reviews, and continuing
professional education .
D . The Commission will consider an application by Respondent to resume
appearing or practicing before the Commission as an accountant provided
that his accountant status is current and he has resolved any disciplinary
issues with the applicable board of accountancy . However, if the resolution
of any disciplinary action by a board of accountancy is dependent o n
reinstatement by the Commission, the Commission will consider an
application on its other merits . The Commission's review may include
consideration of, in addition to the matters referenced above, any other
matters relating to Respondent's character, integrity, professional conduct,
or qualifications to appear or practice before the Commission .
By the Commission .
Jonathan G . Katz
Secretar y
Endnote s
Rule 102(e)(1)(ii) provides, in relevant part, that :
The Commission may censure a person or deny, temporarily or
permanently, the privilege of appearing or practicing before it in any way to
any person who is found . . . to be lacking in character or integrity or to
have engaged in unethical or improper professional conduct .
http ://mix"v .sec .gov/lltigation/admin/34-48542 .htm
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Oliver Flanagan: Adm in. Proc gel. No . 34-48542 September 25, 200'
Page 6 of 6
?The findings herein are made pursuant to Respondent ' s Offer of
Settlement and are not binding on any other person or entity in this or any
other proceeding .
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Exhibit 6
3
0
Comptroller of the Currency
Administrator of National Banks
Washington, DC 2021 9
October 29, 2001
Interpretive Letter #927
March 2002
12 CFR 3
VIA FACSIMILE
Dear [ [ :
This letter is in response to the issues you raised in your October 1 ! letter to the OCC regarding
the appropriate risk-based capital treatment for [ I's securitization transactions . The OCC
has determined that, for risk-based capital purposes, the bank must : (i) reflect recourse treatment
on the securitized assets ; and (ii) demonstrate to the satisfaction of the OCC that its policies and
practices have been sufficiently modified to warrant application of non-recourse treatment to
new securitization transactions . As you were previously instructed by on-site OCC examiners ,
[ J's Report of Condition and Income (Call Report) for the third quarter 2001 should
be filed in a manner consistent with this recourse determination for risk-based capital purposes .
The OCC reviewed [ ]' s securitization program in a recent bank examination and
determined that certain practices constitute a sale of assets with recourse for risk-based capital
purposes. These practices related to the classification of cert ain delinquent accounts as fraud
losses, resulting in repurchase by the bank at par, when the losses were actually attributable to
credit quality. Consequently , the assets that were previously treated as sold under generally
accepted accounting principles and for risk - based capital purposes will be risk weighted as if
they were still on the bank's balance sheet and included in risk-weighted assets for risk-based
capital purposes.
The general rule on recourse, contained in the glossary section of the Call Report instructions,
describes the appropriate capital treatment for implicit recourse .' The instructions state,
1 See the glossary entry "Sales of Assets for Risk-Based Capital Purposes" in the Call Report instructions. These
instructions are incorporated by reference in the OCC's risk- based capital regulations . See 12 CFR Part 3, Appendix
A, Section 3(b)(lXiii), footnote 14 .
"Regardless of the legal structure of the transaction, if risk of loss is retained by the seller, either
contractually or otherwise . . . the seller should treat the transaction as an asset sale with recourse
for purposes of risk-based capital and Schedule RC-R even if the sale . . . is . stated as being
without recourse ."
In your letter, you requested clarification of how the securitized assets should be treated
prospectively . You state that you have "committed to change [your) accounting policies to
eliminate any implication that [your] characterization of certain loan defaults as fraud losses
gives rise to a right of recourse against the bank" . Despite this commitment, the bank's past
practices warrant continued recourse treatment for risk-based capital purposes on a prospective
basis for the securitized assets, the securities backed by those assets, and the master trust from
which the securities were issued.
The general presumption with securitization transactions is that a bank is not exposed to risk of
loss beyond its contractual obligation . It is this presumption that allows banks to treat
securitized assets as sold for risk-based capital purposes (i .e., not apply recourse treatment) .
Once a bank provides support to a securitization beyond the bank's contractual obligation, the
presumption of the bank's limited exposure to loss no longer holds . When a bank provides noncontractual credit support to a securitization, the expectation is raised among securitization
investors and bank supervisors that the bank will provide similar future support if needed .
Allowing a bank to provide support to a securitization and then later allowing that securitization
to receive the risk-based capital benefits of sales treatment can create an incentive for banks to
repeatedly support a deal and subsequently alter their practices so as not to trigger recourse
treatment going forward . Such a situation could result in the bank effectively providing ongoing support to investors, resulting in no risk transference from the bank to third party
investors, with the bank holding capital that is not commensurate with its risk exposure .
Consequently, long-standing general ©CC policy is that once a securitization has been "tainted",
the transferred assets are treated as assets sold with recourse for risk-based capital purposes,
even if a bank immediately stops its practice of providing support to investors .
The OCC has communicated its policy with respect to implicit recourse in a number of ways
over the years. As we have described, the Call Report instructions clearly require recourse
treatment for risk based capital purposes where a bank provides support "contractually or
otherwise" . The 1994 Bank Accounting Advisory Series (BAAS) included an example of an
implicit recourse situation involving the repurchase of performing and delinquent assets from a
securitization trust and the subsequent issuance of a new securitization backed by the performing
assets . Regulatory sales treatment was disallowed for the subsequent securitization of the
repurchased assets . The BAAS noted that all future securitizations by the bank would require
close scrutiny to determine whether implicit recourse existed. Recently issued revisions to the
BAAS (September, 2001) continue to include an example of implicit recourse in which riskbased capital is required for securitized assets after a bank's prior actions have demonstrated the
retention of a risk of loss . The OCC's policy regarding implicit recourse has also been described
in the Comptroller's Handbook on Asset Securitization (November 1997) and the preambles to
the 2000, 1997, and 1994 proposed rules on recourse .
a See "Risk-Based Capital Standards ; Recourse and Direct Credit Substitutes ; Proposed Rule", federal Register,
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In your letter, you requested clarification of whether the OCC would permit sales treatment for
ri sk-based capital purposes for new securities that were exchanged for existing securities, where
the new securities would be identical to the existing securities . The OCC would continue to
require recourse treatment for the assets underlying these new securities . Recourse treatment is
linked not only to the securities issued out of the existing master trust , but also to the receivables
that back those securities. Issuing new securities that are identical to existing securities would
not eliminate the recourse associated with the trust or the outstanding receivable balances that
back those securities .
In order to avoid recourse treatment on any new securitization transactions involving new assets
in a new master trust, the bank must demonstrate to the OCC's satisfaction that it has changed the
practices that have resulted in recourse treatment and that it will not provide support to future
securitizations. Factors that might be considered include an improved ability by the bank to
distinguish between fraud losses and credit losses, trust documents that more clearly define how
losses are to be shared between the bank and the trust, and demonstration over time tha* the
banks practices do not result in support to investors beyond the bank's contractual obligation .
We hope that this letter allows you to better understand our position with respect to your
institution's risk-based capital treatment for securitization transactions . Please feel free to
contact Tommy Snow at (202) 874-5070 if you have any questions .
Sincerely,
!s!
Kevin J . Bailey
Senior Advisor
Bank Supervision Polic y
March 8, 2000 (Volume 65, Number 46) ; "Risk-Based Capital Standards ; Recourse and Direct Credit Substitutes;
Proposed Rule", Federal Register, November 5, 1997 (Volume 62, Number 214) ; and "Risk-Based Capital
Requirements-Recourse and Direct Credit Substitutes", Federal Register, May 25, 1994 (Volume 59, Number 10©) .
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Exhibit 7
NEWS RELEAS E
Comptroller of the Currency
Adm in i s trator of National Banks
N R 2002-09
FOR IMMEDIATE RELEASE Contact : Robert M . Garsson
February 7, 2002 (202) 874-5770
OCC Closes NextBank and Appoints FDIC Receiver
WASHINGTON -- NextBank NA, Phoenix, Arizona, was closed today by the Office of the
Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) was
appointed receiver .
The OCC acted after finding that the bank was operating in an unsafe and unsound manner and had
experi enced a substantial dissipation of assets and ea rnings through unsafe and unsound practices .
The OCC also found that NextBank ' s unsafe and unsound practices were likely to deplete all or
substantially all of the bank ' s capital, and that there was no reasonable prospect for the bank to
become adequately capitalized without federal assistance . In addition , the OCC found that the bank
would be unlik ely to be able to pay its obligations or meet the demands of its depositors in the
normal course of business .
After being acquired by NextCard Inc . on September 16, 1999, NextBank pursued a strategy of
marketing credit cards solely through the Internet. However, the OCC found that the bank's risk
management policies and procedures were inadequate and the bank's assets were of lower credit
quality than initially projected in the bank's business plan . The bank failed to identify the extent of
its credit quality problem or to implement effective corrective measures .
At the OCC's insistence, the board of directors of the bank adopted a detailed board resolution on
October 26, 2000 that was designed to correct these deficiencies, but the bank was unable to
implement the resolution . The bank failed to achieve profitability, and the $3 0 0 million in capital
that had been provided by the bank's parent company, NextCard, Inc ., was dissipated through credit
losses and high operating expenses .
During the bank's most recent examination, the OCC determined that the bank was classifying some
delinquent accounts sold into a securitization trust as fraud losses, although the delinquencies were
actually attributable to credit quality problems . These assets were being repurchased by the bank at
par, a practice that constituted sale of assets with recourse .
This finding, together with significant accounting adjustments and the need for additional loan loss
reserves, resulted in the bank becoming significantly undercapitalized. The OCC issued a Prompt
Corrective Action Directive on November 15, 2001 that required NextBank to restore Tier 1 capital
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to at least 12 percent of risk-weighted assets or commit to sell or liquidate the bank at no cost to the
FDIC.
NextCard, Inc . made efforts to find a buyer for the bank and holding company, but was unsuccessful .
On January 12, 2002, NextCard notified the OCC that it was not possible to prepare and submit a
Capital Restoration Plan, and said liquidation of the bank's assets would not raise enough money to
retire in full the bank's existing and anticipated liabilities . In light of these findings, the OCC
determined that it was necessary to close the bank and appoint the FDIC as receiver to protect the
interests of the bank's insured depositors .
As of December 31, 2001, NextBank had total assets of approximately $700 million and total
deposits of approximately S550 million. NextBank was an Internet -only bank, and had no branch
operations.
The FDIC will release information about the resolution of the bank .
The OCC charters, regulates and examines approximately 2,200 national banks and 52 federal branches of foreign banks
in the U .S., accounting for more than 54 percent of the nation's banking assets . Its mission is to ensure a safe and sound
and competitive national banking system that supports the citizens, communities and economy of the United States .
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