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Listening to its general counsel might well have saved New Century FinancialCorp., once the nation's second-largest subprime mortgage lender, fromplunging into bankruptcy a year ago.

That's one lesson from a 581-page report filed Wednesday by Michael Missal.A partner at Kirkpatrick & Lockhart Preston Gates Ellis, Missal wasappointed by New Century's bankruptcy trustee to investigate the company'sproblems. Missal wrote that former New Century general counsel Stergios"Terry" Theologides recognized the high risk of subprime mortgages andwarned senior managers about it in a memo in the fall of 2004. But no onepaid attention.

Theologides, who left the company last September, could not be reached forcomment. A New Century spokesman said in a statement, "The company ispleased that the examiner's report is completed and that we can take thenext steps of confirming the plan of liquidation, substantially concludingthe bankruptcy process." The Irvine, Calif.-based lender filed forChapter 11 protection in April 2007.

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

Yet New Century continued doing just that. Missal primarily targets thelender's senior management for engaging in "significant improper andimprudent practices" from 2005 to early 2007. But his report also points outthat Theologides was a member of the senior management group that decided tokeep offering risky loans, as well as a member of its compliance committeethat oversaw faulty company practices.

Asked about Theologides' role in the case, Missal says the general counsel"was very much a part of senior management and certainly had influencewithin the company." Missal, who also served as chief examiner in theWorldcom Inc. bankruptcy, declined to elaborate and said the report mustspeak for itself.

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

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

Missal's report also links Theologides -- as well as the company's outsidecounsel, O'Melveny & Myers -- to the lack of a proper process to handledisclosure issues. (Theologides was a former associate at O'Melveny beforehe joined New Century.) And the report criticizes the company's inadequatedisclosure of its risks in public filings, adding that O'Melveny "washeavily involved in discussions concerning what risk factors to include inthe company's filings and in drafting risk factor disclosures."

Missal also blamed O'Melveny for a lack of cooperation with hisinvestigation, and for "seeming adversarial" at times. For example, thereport says New Century "unreasonably withheld ... hundreds of thousandsof important documents." Missal also scolded O'Melveny for meeting with anunidentified senior officer to prepare him for an interview with Missal,even though O'Melveny was not representing this former officer. An O'Melvenyspokesman could not immediately be reached for comment.

A large portion of Missal's report also criticizes the accounting firm KPMGfor condoning improper practices that led to significant errors in NewCentury's financial statements for 2005 and 2006. On Wednesday, KPMG spokesmanDan Ginsburg told The American Lawyer, a sibling publication of CorporateCounsel, that the auditing firm "strongly disagrees" with the report'sconclusions concerning KPMG.

Missal ends his report by discussing what legal actions New Century'sbankruptcy trustee or others may take. First, Missal says KPMG may be liablefor damages "for professional negligence and negligent misrepresentation."Second, Missal says a lawsuit may recover bonuses and other compensationpaid to officers that were tied, directly or indirectly, to the company'smisstated net income. These include quarterly performance-based bonuses,which Theologides and others received.

Third, Missal's report says there is a question "with respect to whetheractions or inaction on the part of individual officers or directors may giverise to potential causes of action." Such a suit would shed more light onwhat Theologides and senior management did, or didn't do, after the generalcounsel's 2004 warning of "sticker shock" risk.

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